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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10 - Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended March 31, 2005
 
Commission File Number 000-50872
 
EUROBANCSHARES, INC.
(Exact name of registrant as specified in its charter)
 
 
Commonwealth of Puerto Rico
  
 
66-0608955
(State or other jurisdiction of
  
(I.R.S. Employer
incorporation or organization)
  
Identification No.)
     
 
270 Muñoz Rivera Avenue, San Juan, Puerto Rico 00918
(Address of principal executive offices, including zip code)
 
(787) 751-7340
(Registrant’s telephone number, including area code)
 
 
Indicate by check mark whether the registrant: (i) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (ii) has been subject to such filing requirements for the past 90 days.
Yes [X] No [  ]
 
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act.)
Yes [ ] No [X] 
 
The number of shares outstanding of the issuer’s Common Stock as of May 13, 2005, was 19,564,086 shares.
 
 


EUROBANCSHARES, INC.
 
INDEX
 
 
PAGE
PART I - FINANCIAL INFORMATION
 1
ITEM 1. FINANCIAL STATEMENTS
 1
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
 18
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 46
ITEM 4. CONTROLS AND PROCEDURES
 46
   
PART II - OTHER INFORMATION 
 47
ITEM 1. LEGAL PROCEEDINGS
 47
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
 47
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
 47
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 47
ITEM 5. OTHER INFORMATION
 47
ITEM 6. EXHIBITS
 47

 
i
 
PART I - FINANCIAL INFORMATION
 
ITEM 1. Financial Statements
 
EUROBANCSHARES, INC. AND SUBSIDIARIES 
 
Condensed Consolidated Balance Sheets
 
March 31, 2005 and December 31, 2004
 
 
    
(Unaudited)
    
 
 
    
March 31,
    
December 31,
  
Assets
    
2005
    
2004
  
 
            
Cash and due from banks
  
$
19,810,490
  
$
18,597,116
  
Interest-bearing deposits
    
5,975,309
    
3,271,377
  
Securities purchased under agreements to resell
    
25,504,761
    
42,810,479
  
Investment securities available for sale:
    
   
 
    Pledged securities with creditors’ right to repledge
    
441,391,708
    
457,247,716
  
    Other securities available for sale
    
93,411,761
    
98,234,027
  
Investment securities held to maturity:
    
   
 
    Pledged securities with creditors’ right to repledge
    
43,498,792
    
34,390,675
  
    Other securities held to maturity
    
4,562,785
    
15,113,768
  
Other investments
    
8,511,550
    
8,715,600
  
Loans held for sale
    
3,091,004
    
2,684,063
  
Loans, net of allowance for loan and lease losses of $17,965,746 in 2005 and $19,038,836 in 2004
    
1,417,106,585
    
1,365,890,375
  
Accrued interest receivable
    
12,152,683
    
11,167,973
  
Customers’ liability on acceptances
    
369,017
    
395,161
  
Premises and equipment, net
    
11,512,121
    
11,261,213
  
Other assets
    
33,550,686
    
33,009,509
  
        Total assets
  
$
2,120,449,252
  
$
2,102,789,052
  
 
    
     
Liabilities and Stockholders’ Equity
    
   
 
Deposits:
    
   
 
    Noninterest bearing
  
$
135,293,984
  
$
137,895,861
  
    Interest bearing
    
1,310,833,546
    
1,271,140,575
  
        Total deposits
    
1,446,127,530
    
1,409,036,436
  
Securities sold under agreements to repurchase
    
442,159,750
    
463,409,056
  
Acceptances outstanding
    
369,017
    
395,161
  
Notes payable to Federal Home Loan Bank
    
10,395,588
    
10,403,638
  
Notes payable to Statutory Trusts
    
46,393,000
    
46,393,000
  
Accrued interest payable
    
7,520,780
    
6,719,851
  
Accrued expenses and other liabilities
    
7,909,054
    
8,130,222
  
 
    
1,960,874,719
    
1,944,487,364
  
 
            
Stockholders’ equity:
    
   
 
   Preferred stock:
    
   
 
    Preferred stock Series A, $0.01 par value. Authorized 20,000,000 shares; issued and outstanding 430,537 shares
    
4,305
    
4,305
  
        Capital paid in excess of par value
    
10,759,120
    
10,759,120
  
   Common stock:
    
   
 
    Common stock, $0.01 par value. Authorized 150,000,000 shares; issued and outstanding 19,564,086 shares
    
195,641
    
195,641
  
        Capital paid in excess of par value
    
105,508,402
    
105,408,402
  
   Retained earnings:
    
   
 
    Reserve fund
    
5,234,852
    
4,721,756
  
    Undivided profits
    
44,438,424
    
40,369,955
  
   Accumulated other comprehensive loss, net of tax
    
(6,566,211
)
  
(3,157,491
)
        Total stockholders’ equity
    
159,574,533
    
158,301,688
  
        Total liabilities and stockholders’ equity
  
$
2,120,449,252
  
$
2,102,789,052
  
 
See accompanying notes to condensed consolidated financial statements.
 
1
 
EUROBANCSHARES, INC. AND SUBSIDIARIES 
 
Condensed Consolidated Statements of Income
 (Unaudited)
 
For the three month periods ended March 31, 2005 and 2004 
 
     
2005
   
2004
  
               
Interest income:
    
   
 
   Loans, including fees
  
$
26,727,734
  
$
16,751,129
  
   Investment securities:
    
   
 
      Available for sale
    
4,334,881
    
2,127,403
  
      Held to maturity
    
472,960
    
—
  
   Interest-bearing deposits, securities purchased under agreements to resell, and other
    
217,189
    
127,810
  
         Total interest income
    
31,752,764
    
19,006,342
  
 
            
Interest expense:
    
   
 
   Deposits
    
9,768,022
    
7,033,199
  
   Securities sold under agreements to repurchase, notes payable, and other
    
3,717,039
    
1,314,122
  
         Total interest expense
    
13,485,061
    
8,347,321
  
         Net interest income
    
18,267,703
    
10,659,021
  
Provision for loan and lease losses
    
1,250,000
    
1,500,000
  
         Net interest income after provision for loan and lease losses
    
17,017,703
    
9,159,021
  
 
            
Noninterest income:
    
   
 
   Service charges - fees and other
    
1,973,613
    
1,636,904
  
   Net loss on non-hedging derivatives
    
(1,075,419
)
  
—
  
   Net loss on sale of securities
    
(230,017
)
  
—
  
   Net loss on sale of repossessed assets and on disposition of other assets
    
(193,257
)
  
(43,782
  
   Gain on sale of loans
    
425,882
    
—
  
         Total noninterest income
    
900,802
    
1,593,122
  
 
            
Noninterest expense:
    
   
 
   Salaries and employee benefits
    
5,739,690
    
4,004,042
  
   Occupancy
    
2,051,290
    
1,532,016
  
   Professional services
    
645,918
    
361,561
  
   Insurance
    
294,021
    
149,508
  
   Promotional
    
132,852
    
115,670
  
   Other
    
1,956,707
    
1,200,740
  
         Total noninterest expense
    
10,820,478
    
7,363,537
  
         Income before income taxes
    
7,098,027
    
3,388,606
  
Provision for income taxes
    
2,332,811
    
1,063,981
  
         Net income
  
$
4,765,216
  
$
2,324,625
  
 
            
Earnings per share:
    
   
 
   Basic
  
$
0.23
  
$
0.17
  
   Diluted
  
$
0.23
  
$
0.16
  
 
    
   
 
See accompanying notes to condensed consolidated financial statements.
    
   
 
 
2
 
EUROBANCSHARES, INC. AND SUBSIDIARIES 
 
Condensed Consolidated Statements of Changes in Stockholders’ Equity
and Comprehensive Income
(Unaudited) 
 
For the three month periods ended March 31, 2005 and 2004 
 
     
2005
   
2004
 
Preferred stock:
    
   
 
   Balance at beginning of period
  
$
4,305
  
$
—
  
   Issuance of preferred stock
    
—
    
—
  
   Balance at end of period
    
4,305
    
—
  
 
            
Capital paid in excess of par value - preferred stock:
    
   
 
   Balance at beginning of period
    
10,759,120
    
—
  
   Issuance of preferred stock
    
—
    
—
  
   Balance at end of period
    
10,759,120
    
—
  
               
Common stock:
    
   
 
   Balance at beginning of period
    
195,641
    
69,737
  
   Issuance of common stock
    
—
    
826
  
   Balance at end of period
    
195,641
    
70,563
  
 
              
Capital paid in excess of par value - common stock:
    
   
 
   Balance at beginning of period
    
105,408,402
    
42,943,014
  
   Issuance of common stock
    
—
    
757,549
  
   Reversal of initial public offering expenses
    
100,000
    
—
  
   Balance at end of period
    
105,508,402
    
43,700,563
  
 
              
Reserve fund:
    
   
 
   Balance at beginning of period
    
4,721,756
    
2,348,598
  
   Transfer from undivided profits
    
513,096
    
232,463
  
   Balance at end of period
    
5,234,852
    
2,581,061
  
 
              
Undivided profits:
    
   
 
   Balance at beginning of period
    
40,369,955
    
20,521,151
  
   Net income
    
4,765,216
    
2,324,625
  
   Preferred stock dividends
    
(183,651
)
  
—
  
   Transfer to reserve fund
    
(513,096
)
  
(232,463
)
   Balance at end of period
    
44,438,424
    
22,613,313
  
 
              
Accumulated other comprehensive (loss) income, net of taxes:
    
   
 
   Balance at beginning of period
    
(3,157,491
)
  
(807,244
)
   Unrealized net loss on investment securities available for sale
    
(3,408,720
)
  
1,852,592
  
   Balance at end of period
    
(6,566,211
)
  
1,045,348
  
         Total stockholders’ equity
  
$
159,574,533
  
$
70,010,848
  
 
              
Comprehensive income:
    
   
 
   Net income
  
$
4,765,216
  
$
2,324,625
  
   Other comprehensive (loss) income, net of tax:
    
   
 
      Unrealized net loss on investment securities available for sale
    
(3,408,720
)
  
1,852,592
  
         Comprehensive income
  
$
1,356,496
  
$
4,177,217
  
 
              
See accompanying notes to condensed consolidated financial statements.
    
   
 
 
3
 
EUROBANCSHARES, INC. AND SUBSIDIARIES 
 
     Condensed Consolidated Statements of Cash Flows
(Unaudited)
 
For the three month periods ended March 31, 2005 and 2004 
 
     
2005
   
2004
 
Cash flows from operating activities:
    
   
 
   Net income
  
$
4,765,216
  
$
2,324,625
  
               
Adjustments to reconcile net income to net cash provided by operating activities:
    
   
 
   Depreciation and amortization
    
1,291,714
    
400,341
  
   Provision for loan and lease losses
    
1,250,000
    
1,500,000
  
   Deferred tax provision (benefit)
    
1,629,905
    
(109,535
)
   Net loss on non-hedging derivatives
    
1,075,419
    
—
  
   Net loss on sale of securities
    
230,017
    
—
  
   Net gain on sale of loans
    
(425,882
)
  
—
  
   Net loss on sale of repossessed assets and on disposition of other assets
    
193,257
    
43,782
  
   Net amortization of premiums and accretion of discounts on investment securities
    
1,541,623
    
985,137
  
   Increase in deferred loan costs
    
(254,109
)
  
(431,845
)
   Origination of loans held for sale
    
(5,076,320
)
  
—
  
   Proceeds from sale of loans held for sale
    
5,137,016
    
—
  
   Increase in accrued interest receivable
    
(984,710
)
  
(679,278
)
   Net increase in other assets
    
(3,497,939
)
  
(263,523
)
   Increase in accrued interest payable, accrued expenses, and other liabilities
    
679,760
    
1,269,572
  
         Net cash provided by operating activities
    
7,554,967
    
5,039,276
  
 
    
   
 
Cash flows from investing actitivies:
    
   
 
   Net decrease in securities purchased under agreements to resell and federal funds sold
    
17,305,718
    
3,482,798
  
   Net (increase) decrease in interest-bearing deposits
    
(2,703,932
)
  
19,324,216
  
   Proceeds from sale of investment securities available for sale
    
39,988,612
    
—
  
   Purchases of investment securities available for sale
    
(50,270,298
)
  
(90,080,949
)
   Proceeds from principal payments and maturities of investment securities available for sale
    
25,513,281
    
31,558,749
  
   Purchases of investment securities held to maturity
    
(400
)
  
(1,297,500
)
   Proceeds from principal payments, maturities, and calls of investment securities held to maturity
    
1,568,253
    
250,000
  
   Net increase in loans
    
(71,941,938
)
  
(62,432,833
)
   Proceeds from sale of loans
    
14,887,833
    
—
  
   Proceeds from sale of repossessed assets and on disposition of other assets
    
4,428,227
    
—
  
   Capital expenditures
    
(766,751
)
  
(338,504
)
         Net cash used in investing activities
    
(21,991,395
)
  
(99,534,023
)
 
    
   
 
Cash flows from financing activities:
    
   
 
   Net increase in deposits
    
37,091,094
    
70,284,067
  
   (Decrease) increase in securities sold under agreements to repurchase
    
(21,249,306
)
  
16,469,500
  
   Repayment of Federal Home Loan Bank Advances
    
(8,050
)
  
—
  
   Dividends paid to preferred stockholders
    
(183,936
)
  
—
  
   Net proceeds from issuance of common stock
    
—
    
758,375
  
         Net cash provided by financing activities
    
15,649,802
    
87,511,942
  
 
            
   Net increase (decrease) in cash and cash equivalents
    
1,213,374
    
(6,982,805
)
   Cash and cash equivalents beginning balance
    
18,597,116
    
22,522,342
  
   Cash and cash equivalents ending balance
  
$
19,810,490
  
$
15,539,537
  
 
            
See accompanying notes to condensed consolidated financial statements. 
 
4
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
1.  
Nature of Operations and Basis of Presentation
 
EuroBancshares, Inc. (the Company or EuroBancshares) was incorporated on November 21, 2001, under the laws of the Commonwealth of Puerto Rico to engage, for profit, in any lawful acts or businesses and serve as the holding company for Eurobank (the Bank). As a financial holding company, the Company is subject to the provisions of the Bank Holding Company Act, and to the supervision and regulation by the board of governors of the Federal Reserve System.
 
The unaudited consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation. These statements are, in the opinion of management, a fair statement of the results for the periods presented. These financial statements are unaudited, but, in the opinion of management, include all necessary adjustments, all of which are of a normal recurring nature, for a fair presentation of such financial statements.
 
The presentation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amount of revenue and expenses during the reporting periods. These estimates are based on information available as of the date of the condensed consolidated financial statements. Therefore, actual results could differ form those estimates.
 
Certain information and note disclosures normally included in the financial statements prepared in accordance with generally accepted accounting principles in the United States of America have been condensed or omitted from these statements pursuant to rules and regulations of the Securities and Exchange Commission and, accordingly, these financial statements should be read in conjunction with the audited consolidated financial statements of the Company for the year ended December 31, 2004. The results of operations for the three month period ended March 31, 2005 are not necessarily indicative of the results to be expected for the full year.
 
2.  
Recent Accounting Pronouncements
 
In December 2004, the SFAS No. 123 was revised. This statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award—the requisite service period (usually the vesting period). No compensation cost is recognized for equity instruments for which employees do not render the requisite service. Employee share purchase plans will not result in recognition of compensation cost if certain conditions are met; those conditions are much the same as the related conditions in SFAS No. 123. A public entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. Under the SEC’s rule, approved in April 2005, FAS 123 (R) will be effective, for public entities that do not file as small business issuers, for annual, rather than interim periods that begin after June 15, 2005. The Company expects to adopt this new implementation for the first quarter of 2006.
 
5
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
3.  
Earnings Per Share
 
Basic earnings per share represent income available to common stockholders divided by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.
 
The computation of earnings per share is presented below:

 
    
Three months ended March 31, 
  
     
2005
    
2004
  
    Income before preferred stock dividends
  
$
4,765,216
  
$
2,324,625
  
    Preferred stock dividend
    
(183,651
)
  
–
 
Income available to common shareholders
  
$
4,581,565
  
$
2,324,625
  
Weighted average number of common shares outstanding applicable to basic EPS
    
19,564,086
   
14,033,977
 
    Effect of dilutive securities
   
795,936
   
428,911
 
       Adjusted weighted average number of common shares outstanding applicable to diluted earnings per share
    
20,360,022
   
14,462,888
 
    Net income per share:
              
    Basic
  
$
0.23
  
$
0.17
  
    Diluted
    
0.23
    
0.16
  
 
4.  
Investment Securities Available for Sale
 
Investment securities available for sale and related contractual maturities as of March 31, 2005 and December 31, 2004 are as follows:

     
2005
  
 
    
Amortized 
    
Gross unrealized
    
Gross unrealized
    
Fair
  
 
    
cost 
    
gains
    
losses
    
value
  
Commonwealth of Puerto Rico obligations:
                          
Less than one year
  
$
1,503,624
  
$
3,560
  
$
(1,844
)
$
1,505,340
  
One through five years
    
6,260,020
   
13,106
   
(32,813
)
  
6,240,313
 
More than ten years
    
1,706,308
   
14,869
   
(14,656
)
  
1,706,521
 
U.S. treasury obligations:
                          
Less than one year
    
44,924,986
   
—
   
(319,516
)
  
44,605,470
 
Federal Home Loan Bank notes:
                          
Less than one year
    
38,522,250
   
—
   
(704,711
)
  
37,817,539
 
One through five years
    
48,627,652
   
—
   
(706,662
)
  
47,920,990
 
Federal National Mortgage Association notes:
                          
Less than one year
    
4,997,319
   
—
   
(161,649
)
  
4,835,670
 
One through five years
    
2,467,847
   
590
   
—
   
2,468,437
 
Federal Home Loan Mortgage Association notes:
                          
One through five years
    
3,004,112
   
—
   
(44,312
)
  
2,959,800
 
Mortgage-backed securities
    
389,347,481
   
590,709
   
(5,194,801
)
  
384,743,389
 
Total 
  
$
541,361,599
  
$
622,834
  
$
(7,180,964
)
$
534,803,469
  
                           
 
6
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 

     
2004
  
 
    
Amortized 
    
Gross unrealized
    
Gross unrealized
    
Fair
  
 
    
cost 
    
gains
    
losses
    
value
  
Commonwealth of Puerto Rico obligations:
                          
Less than one year
  
$
1,506,276
  
$
8,960
  
$
(905
)
$
1,514,331
  
One through five years
    
6,264,714
   
39,714
   
(13,920
)
  
6,290,508
 
More than ten years
    
1,706,383
   
15,429
   
(12,819
)
  
1,708,993
 
U.S. treasury obligations:
                          
Less than one year
    
84,882,054
   
—
   
(489,884
)
  
84,392,170
 
Federal Home Loan Bank notes:
                          
Less than one year
    
37,517,099
   
—
   
(237,465
)
  
37,279,634
 
One through five years
    
41,391,666
   
—
   
(257,723
)
  
41,133,943
 
Federal National Mortgage Association notes:
                          
One through five years
    
7,461,983
   
—
   
(49,295
)
  
7,412,688
 
Federal Home Loan Mortgage Corporation notes:
                          
One through five years
    
3,005,088
   
—
   
(32,433
)
  
2,972,655
 
Mortgage-backed securities
    
374,320,227
   
1,385,436
   
(2,928,842
)
  
372,776,821
 
Total 
  
$
558,055,490
  
$
1,449,539
  
$
(4,023,286
)
$
555,481,743
  
                           
Contractual maturities on certain investment securities available for sale could differ from actual maturities since certain issuers have the right to call or prepay these securities.
 
During the three months ended March 31, 2005, proceeds from sales of investment securities were approximately $39,989,000 and net losses of approximately $230,000 were realized. At December 31, 2004, there were no sales of investment securities.
 
Gross unrealized losses on investment securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at March 31, 2005, were as follows:

 
    
Less than 12 months 
    
12 months or more
    
Total
  
 
    
Unrealized 
    
Fair
    
Unrealized
    
Fair
    
Unrealized
    
Fair
  
 
    
losses 
    
value
    
losses
    
value
    
losses
    
value
  
U.S. agency debt securities
  
$
(1,599,662
)
$
84,294,696
  
$
(17,672
)
$
979,302
  
$
(1,617,334
)
$
85,273,998
  
State and municipal obligations
    
(49,313
)
  
4,737,553
   
—
   
—
   
(49,313
)
  
4,737,553
 
U.S. treasury obligations
    
(319,516
)
  
44,605,470
   
—
   
—
   
(319,516
)
  
44,605,470
 
Mortgage-backed securities
    
(4,790,633
)
  
289,463,798
   
(404,168
)
  
34,868,948
   
(5,194,801
)
  
324,332,746
 
   
$
(6,759,124
)
$
423,101,517
  
$
(421,840
)
$
35,848,250
  
$
(7,180,964
)
$
458,949,767
  
 
·  
U.S. Agency Debt Securities - The unrealized losses on investments in U.S. agency debt securities were caused by interest rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.
 
·  
U.S. Treasury Obligations - The unrealized losses on investment in U.S. Treasury obligations were caused by interest rate increases. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.
 
7
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
·  
Mortgage-Backed Securities - The unrealized losses on investments in mortgage-backed securities were caused by interest rate increases. The contractual cash flows of these securities are guaranteed by Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC). It is expected that the securities would not be settled at a price less than the amortized cost of the investment. Because the decline in fair value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered other-than-temporarily impaired.
 
5.  
Investment Securities Held to Maturity
 
Investment securities held to maturity as of March 31, 2005 and December 31, 2004 are as follows:

     
2005
  
 
    
Amortized 
    
Gross unrealized
    
Gross unrealized
    
Fair
  
 
    
cost 
    
gains
    
losses
    
value
  
Federal Home Loan Bank Notes:
                          
Five through ten years
  
$
4,562,784
  
$
—
  
$
(77,654
)
$
4,485,130
  
Mortgage-backed securities
    
43,498,793
   
20,833
   
(500,134
)
  
43,019,492
 
Total 
  
$
48,061,577
  
$
20,833
  
$
(577,788
)
$
47,504,622
  
                           
 
     
2004
  
 
    
Amortized 
    
Gross unrealized
    
Gross unrealized
    
Fair
  
 
    
cost 
    
gains
    
losses
    
value
  
Federal Home Loan Bank Notes:
                          
Five through ten years
  
$
4,813,645
  
$
—
  
$
(38,338
)
$
4,775,307
  
Mortgage-backed securities
    
44,690,798
   
183,194
   
(342,738
)
  
44,531,254
 
Total 
  
$
49,504,443
  
$
183,194
  
$
(381,076
)
$
49,306,561
  
                           
 
Contractual maturities on certain investment securities held to maturity could differ from actual maturities since certain issuers have right to call or prepay these securities.
 
There were no sales of investment securities held to maturity during the three-month period ended March 31, 2005 and during the year ended December 31, 2004.
 
6.  
Other Investments
 
Other investments at March 31, 2005 and December 31, 2004 consist of the following:

     
2005
    
2004
  
FHLB stock, at cost
  
$
7,126,800
    
7,330,100
 
Investment in statutory trusts
    
1,384,750
   
1,385,500
 
Other investments 
  
$
8,511,550
    
8,715,600
 

8
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
7.  
Loans
 
A summary of the Company’s loan portfolio at March 31, 2005 and December 31, 2004 is as follows:

     
2005
    
2004
  
Commercial and industrial secured by real estate
  
$
495,494,549
  
$
463,500,209
  
Other commercial and industrial
    
257,078,503
   
242,479,758
 
Construction secured by real estate
    
78,506,001
   
79,334,108
 
Other construction
    
1,248,948
   
1,123,435
 
Mortgage
    
49,292,605
   
51,730,399
 
Consumer secured by real estate
    
1,346,003
   
1,311,343
 
Other consumer
    
72,895,997
   
74,755,008
 
Lease financing contracts
    
465,992,216
   
459,250,841
 
Overdrafts
    
7,587,609
   
6,133,558
 
     
1,429,442,431
   
1,379,618,659
 
Deferred loan costs, net
    
6,733,890
   
6,479,782
 
Unearned finance charges
    
(1,103,990
)
  
(1,169,230
)
Allowance for loan and lease losses
    
(17,965,746
)
  
(19,038,836
)
Loans, net 
  
$
1,417,106,585
  
$
1,365,890,375
  
 
The following is a summary of information pertaining to impaired loans at March 31, 2005 and December 31, 2004:

     
2005
    
2004
  
Impaired loans with related allowance
  
$
13,095,000
  
$
14,230,000
  
Impaired loans that did not require allowance
    
10,308,000
   
9,429,000
 
Total impaired loans 
  
$
23,403,000
  
$
23,659,000
  
Allowance for impaired loans
  
$
924,000
  
$
924,000
  
 
No additional funds are committed to be advanced in connection with impaired loans.
 
As of March 31, 2005 and 2004, loans in which the accrual of interest has been discontinued amounted to $29,024,072 and $20,005,023, respectively. If these loans had been accruing interest, the additional interest income realized would have been approximately $703,000 and $321,000 for 2005, and 2004, respectively.
 
Commercial and industrial loans with principal outstanding balance amounting to approximately $3,338,000 as of March 31, 2005, are guaranteed by the U.S. government through the Small Business Administration at percentages varying from 75% to 90%. As of March 31, 2005, industrial loans with a principal outstanding balance of approximately $1,555,000 were guaranteed by the U.S. government through the U.S. Department of Agriculture.
 
9
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
8.  
Allowance for Loan and Lease Losses
 
The following analysis summarizes the changes in the allowance for loan and lease losses for the three-month periods ended March 31:

     
2005
    
2004
  
Balance, beginning of period
  
$
19,038,836
  
$
9,393,943
 
Provision for loan losses
    
1,250,000
   
1,500,000
 
Loans charged-off
    
(2,997,262
)
  
(1,325,410
)
Recoveries
    
674,172
   
312,352
 
Balance, end of period
  
$
17,965,746
  
$
9,880,885
 
 
9.  
Other Assets
 
Other assets at March 31, 2005 and December 31, 2004 consist of the following:

     
2005
    
2004
  
        Deferred tax assets, net
  
$
10,761,633
  
$
12,523,726
  
        Merchant credit card items in process of collection
    
1,843,524
   
1,845,113
 
        Auto insurance claims receivable on repossessed vehicles
   
1,587,445
   
1,228,858
 
        Accounts receivable
    
1,705,260
   
1,337,594
 
Other real estate, net of valuation allowance of $58,779 and $22,779 in March 31, 2005 and December 31, 2004, respectively
    
3,628,015
   
2,875,002
 
        Other repossessed assets, net of valuation allowance of $1,151,388 and $1,493,305 in March 31, 2005 and December 31, 2004, respectively
    
5,498,760
   
3,566,446
 
      Servicing assets, net of valuation allowance of $1,003,618 in March 31, 2005 and December 31, 2004
    
3,564,189
   
3,554,276
 
        Prepaid expenses, deposits and other assets
    
4,961,860
   
6,078,494
 
   
$
33,550,686
  
$
33,009,509
  
 
Other repossessed assets are presented net of an allowance for losses. The following analysis summarizes the changes in the allowance for losses for the three-month periods ended March 31:

     
2005
    
2004
  
Balance, beginning of period
  
$
1,493,305
  
$
885,135
 
Provision for losses
    
130,000
   
163,000
 
Net charge-offs
    
(471,917
)
  
(129,700
)
Balance, end of period
  
$
1,151,388
  
$
918,435
 
 
10
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
10.  
Deposits
 
Total interest bearing deposits as of March 31, 2005 and December 31, 2004 consisted of the following:

     
2005
    
2004
  
               
Non interest bearing deposits
  
$
135,293,984
  
$
137,895,861
  
               
Interest bearing deposits:
              
NOW & Money Market
    
127,188,706
   
118,076,729
 
Savings
    
276,484,133
   
278,802,480
 
Broker Deposits
    
553,296,248
   
512,004,726
 
Regular CD's & IRAS
    
155,996,573
   
161,782,687
 
Jumbo CD's
    
197,867,886
   
200,473,953
 
     
1,310,833,546
   
1,271,140,575
 
Total Deposits
  
$
1,446,127,530
  
$
1,409,036,436
  
 
11.  
Advances from FHLB
 
At March 31, 2005, the Company owes several advances to the FHLB as follows:

Maturity
    
Interest rate range
    
2005
  
2005
    
2.63
%
$
1,600,000
  
2006
    
4.81% to 5.72
%
  
7,000,000
 
2007
    
5.20
%
  
1,200,000
 
2014
    
4.38
%
  
595,588
 
         
$
10,395,588
  
 
Interest rates are fixed for the term of each advance and are payable on the first business day of the following month when the original maturity of the note exceeds six months. In notes with original terms of six months or less, interest is paid at maturity. Interest payments as of March 31, 2005 and 2004 amounted to approximately $124,000 and $151,000, respectively. These notes are guaranteed by approximately $10,257,000 in securities and $844,000 in mortgage loans as of March 31, 2005.
 
12.  
Derivative Financial Instruments
 
Interest-rate swaps involve the exchange of fixed and floating interest-rate payments without an exchange of the underlying principal. The Company’s principal objective in holding interest-rate swap agreements is the management of interest-rate risk and related changes in the fair value or cash flows of assets and liabilities. The Company’s policy is that each swap contract be specifically tied to assets or liabilities with the objective of transforming the interest-rate characteristics of the instrument.
 
11
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
As of March 31, 2005, the Company had the following derivative financial instruments outstanding:

 
    
Notional
                
 
    
amount
    
Fair value
    
Net gain (loss)
 
  
Prime Rate interest rate swaps
  
$
42,500,000
  
$
(815,821
)
$
(1,342,027
 )(1)
 
Libor Rate interest rate swaps
    
50,227,000
   
(1,470,734
)
  
266,608
 (1)
   
$
92,727,000
  
$
(2,286,555
)
$
(1,075,419
)
  
 
             (1) Included in net loss on non-hedging derivatives.
                      
 
The derivatives instruments were assumed in connection the acquisition of BankTrust in May 2004. As of March 31, 2004, the Company had no outstanding derivative instruments.
 
As of March 31, 2005, the Company had three Prime Rate swaps agreements intended to hedge commercial loans and offset the risk of decrease in floating interest rates. The swaps have an aggregate notional amount of $42,500,000 maturing through the year 2007. The weighted average rates payable and receivable as of March 31, 2005 on these contracts were 5.75% and 6.017%, respectively. These agreements were subsequently terminated in April 2005.
 
As of March 31, 2005, the Company also had nine Libor Rate swaps intended to convert fixed-rate time deposits into variable rate liabilities to protect against adverse changes in the fair value of those deposits. These swaps have an aggregate notional amount of $50,227,000 and maturities through the year 2023. The weighted average rates payable and receivable as of March 31, 2005 on these contracts were 3.341% and 4.8228%, respectively.
 
As a result of discontinuing hedge accounting, the interest rate swaps were recorded at fair value with changes in the fair value reflected as net loss on non-hedging derivatives. During the quarter ended March 31, 2005 the Company recorded a loss on non-hedging derivatives of $1,075,419.
 
13.  
Notes Payable to Statutory Trusts
 
On December 18, 2001, the Trust issued $25,000,000 of floating rate Trust Preferred Capital Securities Series 1 due in 2031 with a liquidation amount of $1,000 per security. Distributions payable on each capital security is payable at an annual rate equal to 5.60% beginning on (and including) the date of original issuance and ending on (but excluding) March 18, 2002, and at an annual rate for each successive period equal to the three-month LIBOR, plus 3.60% with a ceiling rate of 12.50%. The capital securities of the Trust are fully and unconditionally guaranteed by EuroBancshares. The Company then issued $25,774,000 of floating rate junior subordinated deferrable interest debentures to the Trust due in 2031. The terms of the debentures, which comprise substantially all of the assets of the Trust, are equal to the terms of the capital securities issued by the Trust. These debentures are fully and unconditionally guaranteed by the Bank. The Bank subsequently issued an unsecured promissory note to EuroBancshares for the issued amount and at an annual rate equal to that being paid on the Trust Preferred Capital Securities Series 1 due in 2031.
 
On December 19, 2002, the Trust II issued $20,000,000 of floating rate Trust Preferred Capital Securities due in 2032 with a liquidation amount of $1,000 per security. Distributions payable on each capital security will be payable at an annual rate equal to 4.66% beginning on (and including) the date of original issuance and ending on (but excluding) March 26, 2003, and at an annual rate for each successive period equal to the three-month LIBOR plus 3.25% with a ceiling rate of 11.75%. The capital securities of the Trust II are fully and unconditionally guaranteed by EuroBancshares. The Company then issued $20,619,000 of floating rate junior subordinated deferrable interest debentures to the Trust II due in 2032. The terms of the debentures, which comprise substantially all of the assets of the Trust II, are equal to the terms of the capital securities issued by the Trust II. These debentures are fully and unconditionally guaranteed by the Bank. The Bank subsequently issued an unsecured promissory note to the EuroBancshares for the issued amount and at an annual rate equal to that being paid on the Trust Preferred Capital Securities due in 2032.
 
12
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
Prior to FIN No. 46R, the statutory trusts described above, were considered subsidiaries of the Company. As a result of the adoption of FIN No. 46R, the Company deconsolidated these statutory trusts effective December 31, 2003. The junior subordinated debentures issued by the Company to the statutory trusts, totaling $46,393,000 are reflected in the Company’s consolidated balance sheets under the caption of “notes payable to statutory trusts”. The Company records interest expense on the notes payable to statutory trusts in the consolidated statements of income and included in the caption of other investments in the consolidated balance sheets, the common securities issued by the statutory trusts.
 
Interest expense on notes payable to statutory trusts amounted to approximately $699,000 and $535,000 for the periods ended March 31, 2005, and 2004, respectively.
 
The Federal Reserve Board indicated in supervisory letter SR 03-13 (the Supervisory Letter), dated July 2, 2003, that trust preferred securities will be treated as Tier 1 capital until notice is given of the contrary. The Supervisory Letter also indicates that the Federal Reserve will review the regulatory implications of any accounting treatment changes and will provide further guidance if necessary or warranted.
 
On March 1, 2005 the Federal Reserve Board adopted the final rule that allows the continued limited inclusion of trust preferred securities in the tier 1 capital of bank holding companies (BHCs). Under the final rule, trust preferred securities and other restricted core capital elements would be subject to stricter quantitative limits. The Federal Reserve Board’s final rule limits restricted core capital elements to 25% of all core capital elements, net of goodwill less any associated deferred tax liability. Internationally active BHCs, defined as those with consolidated assets greater than $250 billion or on-balance-sheet foreign exposure greater than $10 billion, will be subject to a 15% limit. But they may include qualifying mandatory convertible preferred securities up to the generally applicable 25% limit. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. The final rule provides a five-year transition period, ending March 31, 2009, for application of the quantitative limits.
 
14.  
Commitments and Contingencies
 
The Company is involved as plaintiff or defendant in a variety of routine litigation incidental to the normal course of business. Management believes, based on the opinion of legal counsel, that it has adequate defense or insurance protection with respect to such litigations and that any losses therefrom, whether or not insured, would not have a material adverse effect on the results of operations or financial position of the Company.
 
The Bank was defendant in a suit filed in 1994 alleging that money was permitted to be withdrawn from a corporate account at the Bank without full written authorization. On March 30, 2004, the trial court ruled against the Bank ordering restoration of approximately $890,000 in funds, interest thereon, and attorney’s fees. While the trial court found in favor of plaintiff, the Bank appealed the decision to the Appeals Court of Puerto Rico. On March 18, 2005, the Appeals Court reversed the trial court’s decision and ruled in favor of the Bank. However, on April 27, 2005, the plaintiff filed a writ of certiorari before the Supreme Court of Puerto Rico. If the writ of certiorari is granted, management believes that the Supreme Court will affirm the appeals court decision based on legal precedent which they feel favors their position.
 
15.  
Stock Transactions
 
During 2004, EuroBancshares issued 230,802 of the common stock shares, through stock options exercised as follows:

 
    
Number of
              
Date
    
shares
    
Price
    
Total
  
                     
January-04
    
50,000
 
$
5.000
  
$
250,000
  
March-04
    
30,000
   
3.325
   
99,750
 
March-04
    
35,250
   
4.500
   
158,625
 
March-04
    
50,000
   
5.000
   
250,000
 
November-04
    
32,776
   
3.325
   
108,980
 
December-04
    
32,776
   
3.325
   
108,980
 
     
230,802
       
$
976,335
  
 
The Company also issued 3,700 common shares valued at $8.13 per share through restricted stock grants to certain employees in 2004.
 
In addition, during 2004 the Company also issued 683,304 common shares valued at $8.13 per share and 430,537 shares of perpetual noncumulative preferred stock Series A as a result of the acquisition of BankTrust.
 
13
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
The Series A preferred stockholders are entitled to receive, when and if declared by the board of directors, monthly noncumulative cash dividends at an annual rate of 6.825%. The board of directors has no obligation to declare dividends on the Series A preferred stock in any dividend period. However, so long as any Series A preferred stock remains outstanding, there are certain limitations on the payment of dividends or distributions on common stock. The Series A preferred stock is not convertible or exchangeable for any other class of stock. The stock is redeemable at the option of the Company at redemption price of $25.00 per share, plus accrued but unpaid dividends (noncumulative), which is equal to its liquidation value. The stock has no voting preferences and has no preemptive rights.
 
Also, in connection with the acquisition of BankTrust on May 12, 2004, the Company issued 733,316 shares of common stock at a price of $8.13 to its common stockholders and to holders of options to purchase its common stock who were not otherwise stockholders through a private placement offering.
 
On June 21, 2004, the board of directors authorized a two-for-one common stock split in the form of a stock dividend. The stock dividend was distributed on July 15, 2004 to stockholders of record on July 1, 2004. All share data and earnings per share data in these financial statements give effect to the stock split, applied retroactively, to all periods.
 
On July 15, 2004, the Company purchased and retired approximately 1,932 shares of its outstanding common stock, $0.01 par value, at a price of $4.50 per share.
 
On August 11, 2004, the Company completed an initial public offering in which the Company sold 3,450,000 shares of common stock, plus an additional 517,500 shares in connection with the exercise of the underwriters’ over allotment option, at the initial offering price of $14.00 per share. Total proceeds received from the offering, after deducting offering expenses, including underwriting discounts and commissions, were approximately $50.1 million.
 
During 2003, EuroBancshares issued 34,013 of the common stock shares at $7.87 per share through stock options exercised.
 
As a result of the reorganization into a holding company (note 1), on July 1, 2002, EuroBancshares became the sole owner of the Bank’s common stock. As part of such reorganization, the outstanding 6,788,421 shares of the Bank’s common stock, $1 par value, were exchanged to 6,788,421 shares of EuroBancshares common stock, $0.01 par value per share. Also as part of the reorganization, during 2002 EuroBancshares purchased and retired approximately 9,707 shares of its outstanding common stock, $0.01 par value, held by the remaining minority stockholders at a price of $9.00 per share.
 
During 2002, EuroBancshares issued 38,750 of its common stock shares at $4.00 per share through stock options exercised. In addition, as a result of the acquisition of Banco Financiero (note 3), EuroBancshares also issued 122,228 shares of its common stock, $0.01 par value, at a price of $10 per share, amounting to $1,222,280.
 
During 2002, the Bank issued 9,924 of the common stock shares at $3.33 per share through stock options exercised.
 
16.  
Stock Option Plan
 
On March 28, 2005, our Board of directors formally adopted the 2005 Stock Option Plan. The 2005 Stock Option Plan was formally adopted by our stockholders at the 2005 annual meeting of stockholders held on May 12, 2005. The 2005 stock option plan provides for equity-based compensation incentives through the grant of stock options. The plan has reserved 700,000 shares of our common stock for issuance pursuant to the stock options.
 
During 2002, the board of directors approved the stock option plan (the 2002 Plan), which was ratified at a special meeting of stockholders. Under the 2002 Plan, 1,982,864 shares of authorized common stock of the Company, representing 10% of the shares of common stock outstanding of February 25, 2002, were reserved for issuance under the 2002 Plan. The outstanding options as of March 31, 2005 include options granted under a stock option plan held by the Bank until our reorganization into a bank holding company structure.
 
14
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
All officers and directors of EuroBancshares are eligible under the stock option plans, provided, however, that stock options shall not be exercisable by an optionee who is the owner of 5% or more of the issued and outstanding shares of the Company or in exercising the stock options would become the owner of 5% or more of the issued and outstanding shares of the Company, unless the optionee obtains the approvals required from the appropriate regulatory agencies to hold shares in excess of such percent. Any eligible person may hold more than one option at a time.
 
The compensation committee, appointed by the board of directors, has absolute discretion to select which of the eligible persons will be granted stock options, the number of shares of the Company’s common stock subject to such options, whether stock appreciation rights will be granted for such options, and generally, to determine the terms and conditions of such options in accordance to the provisions of the stock option plans. Options are exercisable within five years after the grant date at the discretion of the optionee. The options are granted at the approximate fair value of the Company’s common stock at the date of issuance, accordingly no compensation expense has been recorded during the three-month periods ended March 31, 2005 and 2004.
 
A summary of the status of stock options under the 2002 Plan at March 31, 2005 and 2004, and changes during the three-month periods then ended is presented in the table below:

     
2005
    
2004
  
 
          
Weighted 
          
Weighted
  
 
          
average 
          
average
  
 
          
exercise 
          
exercise
  
 
    
Shares 
    
price
    
Shares
    
price
  
    Options outstanding at January 1
    
1,091,312
 
$
5.22
    
1,122,114
 
$
4.50
  
    Granted
    
125,000
   
21.00
   
200,000
   
8.13
 
    Exercised
    
—
   
—
   
(165,250
)
  
4.59
 
Options outstanding and exercisable at March 31
    
1,216,312
 
$
5.08
    
1,156,864
 
$
5.11
  
 
The following is a summary of outstanding and exercisable options under the 2002 Plan at March 31, 2005:
 

 
    
Options 
                    
 
    
outstanding 
    
Exercise
              
Date granted
    
and exercisable
    
price
    
Exercisable date
    
Expiration date
  
2001
    
150,000
 
$
3.33
    
February 28, 2001
    
February 28, 2006
  
2002
    
267,312
   
4.50
   
February 26, 2002
    
February 26, 2007
  
2003
    
474,000
   
5.00
   
March 24, 2003
    
March 24, 2008
  
2004
    
200,000
   
8.13
   
February 23, 2004
    
February 23, 2009
  
2005
    
125,000
   
21.00
   
February 28, 2005
    
February 28, 2010
  
     
1,216,312
                   
 
As allowed by SFAS No. 123, Accounting for Stock-Based Compensation, and as amended by SFAS No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123, the Company has elected to continue to measure cost for its stock compensation plan using the intrinsic value method prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Under the intrinsic value method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date or other measurement over the amount an employee must pay to acquire the stock. Entities choosing to continue applying APB Opinion No. 25 on employee stock options granted on or after January 1996 must provide pro forma disclosures of the consolidated net income, as if the fair value method of accounting had been applied. Under this method, compensation cost is measured at the grant date based on the fair value of the employee stock option and is recognized ratably over the service period of the option, which is usually the vesting period.
 
15
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
SFAS No. 123 established accounting and disclosure requirements using a fair value based method of accounting for stock-based employee compensation plans. The per share fair value of stock options granted during 2005 and 2004 was $2.67 and $1.12 on the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2005 and 2004, respectively: no dividend yield; risk-free interest rates of 4.00% and 3.03%; volatility assumption of 18.83% and none for 2004; and expected life of five years.
 
The following table illustrates the effect on net income if the fair value based method had been applied to all outstanding stock-based compensation in each period.

 
    
Three Months Ended March 31 
  
     
2005
    
2004
  
    Net income, as reported
  
$
4,765,216
  
$
2,324,625
  
Deduct total stock-based employee compensation expense determined under fair value based method for all awards
    
(333,592
)
  
(223,488
)
Pro forma net income 
  
$
4,431,624
  
$
2,101,137
  
    Earnings per share:
              
    Basic – as reported
  
$
0.23
  
$
0.17
  
    Basic – pro forma
    
0.22
   
0.15
 
    Diluted – as reported
    
0.23
   
0.16
 
      Diluted – pro forma    
0.21
   
0.14
 
 
17.  
Regulatory Matters
 
The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of their assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
 
Quantitative measures established by regulations to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I Capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I Capital (as defined) to average assets (Leverage) (as defined). Management believes, as of March 31, 2005 and 2004, that the Company and the Bank met all capital adequacy requirements to which they are subject.
 
The most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier I risk-based, and Tier I Leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the institution’s capital category. The Company’s and the Bank’s actual capital amounts and ratios as of March 31, 2005 are also presented in the table.

16
EUROBANCSHARES, INC. AND SUBSIDIARIES
Notes to Condensed Consolidated Financial Statements
(Unaudited)
 
At March 31, 2005 required and actual regulatory capital amounts and ratios are as follow (dollars in thousands):

     
2005
  
 
                            
Well 
  
 
    
Required 
          
Actual
          
capitalized
  
 
    
amount 
    
Ratio
    
amount
    
Ratio
    
ratio
  
Total Capital (to risk-weighted assets):
                                
Consolidated
  
$
131,850
    
8.00
%
$
228,168
    
13.84
%
  
N/A
  
Eurobank
    
132,526
   
8.00
%
  
177,350
   
10.71
%
  
>10.00
%
                                 
Tier I Capital (to risk-weighted assets):
                                
Consolidated
    
65,925
   
4.00
%
  
209,998
   
12.74
%
  
N/A
  
Eurobank
    
66,263
   
4.00
%
  
139,180
   
8.40
%
  
>6.00
%
                                 
Tier I Capital (to average assets):
                                
Consolidated
    
84,045
   
4.00
%
  
209,998
   
9.99
%
  
N/A
  
Eurobank
    
83,983
   
4.00
%
  
139,180
   
6.63
%
  
>5.00
%
                                 
                                 
                                 

 
17
 
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
 
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
 
The following discussion and analysis presents our consolidated financial condition and results of operations for the three months ended March 31, 2005 and 2004. The discussion should be read in conjunction with our financial statements and the notes related thereto which appear elsewhere in this Quarterly Report on Form 10-Q.
 
Statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, including our expectations, intentions, beliefs, or strategies regarding the future. Any statements in this document about expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. These statements are often, but not always, made through the use of words or phrases such as “may,” “should,” “could,” “predict,” “potential,” “believe,” “will likely result,” “expect,” “will continue,” “anticipate,” “seek,” “estimate,” “intend,” “plan,” “projection,” “would” and “outlook,” and similar expressions. Accordingly, these statements involve estimates, assumptions and uncertainties, which could cause actual results to differ materially from those expressed in them. Any forward-looking statements are qualified in their entirety by reference to the factors discussed throughout this document. All forward-looking statements concerning economic conditions, rates of growth, rates of income or values as may be included in this document are based on information available to us on the dates noted, and we assume no obligation to update any such forward-looking statements. It is important to note that our actual results may differ materially from those in such forward-looking statements due to fluctuations in interest rates, inflation, government regulations, economic conditions, customer disintermediation and competitive product and pricing pressures in the geographic and business areas in which we conduct operations, including our plans, objectives, expectations and intentions and other factors, including the following:
 
·  
if a significant number of our clients fail to perform under their loans, our business, profitability, and financial condition would be adversely affected;
 
·  
our current level of interest rate spread may decline in the future, and any material reduction in our interest spread could have a material impact on our business and profitability;
 
·  
the modification of the Federal Reserve Board’s current position on the capital treatment of our junior subordinated debt and trust preferred securities could have a material adverse effect on our financial condition and results of operations;
 
·  
adverse changes in domestic or global economic conditions, especially in the Commonwealth of Puerto Rico, could have a material adverse effect on our business, growth, and profitability;
 
·  
we could be liable for breaches of security in our online banking services, and fear of security breaches could limit the growth of our online services;
 
·  
maintaining or increasing our market share depends on market acceptance and regulatory approval of new products and services;
 
·  
significant reliance on loans secured by real estate may increase our vulnerability to downturns in the Puerto Rico real estate market and other variables impacting the value of real estate;
 
·  
if we fail to retain our key employees, growth and profitability could be adversely affected;
 
·  
we may be unable to manage our future growth;
 
·  
we have no current intentions of paying cash dividends on common stock;
 
·  
increases in our allowance for loan and lease losses could materially adversely affect our earnings;
 
·  
our directors and executive officers beneficially own a significant portion of our outstanding common stock;
 
18
 
·  
the market for our common stock is limited, and potentially subject to volatile changes in price;
 
·  
we face substantial competition in our primary market area;
 
·  
we are subject to significant government regulation and legislation that increases the cost of doing business and inhibits our ability to compete; and
 
·  
we could be negatively impacted by downturns in the Puerto Rican economy.
 
These factors could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements made by us, and you should not place undue reliance on any such forward-looking statements. Any forward-looking statement speaks only as of the date on which it is made and we do not undertake any obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for us to predict which will arise. In addition, we cannot assess the impact of each factor on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements.
 
Executive Overview
 
Introduction
 
We are a diversified financial holding company headquartered in San Juan, Puerto Rico, offering a broad array of financial services through our wholly owned banking subsidiary, Eurobank, and our wholly owned insurance agency subsidiary, EuroSeguros, Inc. As of March 31, 2005, we had, on a consolidated basis, total assets of $2.1 billion, net loans and leases of $1.4 billion, total deposits of $1.4 billion, and stockholders’ equity of $159.6 million. We currently operate through a network of 21 branch offices located throughout Puerto Rico. On May 3, 2004, we acquired all of the capital stock of The Bank & Trust of Puerto Rico (BankTrust), a commercial bank headquartered in San Juan, Puerto Rico with approximately $522.0 million in assets.
 
Over the past three years, we have experienced significant balance sheet growth. Our management team has implemented a strategy of building our core banking franchise by focusing on commercial loans, business transaction accounts, our lease financing business and acquisitions. We believe that this strategy will increase recurring revenue streams, enhance profitability, broaden our product and service offerings and continue to build stockholder value.
 
Key Performance Indicators at March 31, 2005
 
We believe the following were key indicators of our performance and results of operations through the first quarter of 2005:
 
·  
our total assets grew to $2.120 billion at the end of the first quarter of 2005, representing an increase of 0.84%, from $2.103 billion at the end of 2004;
 
·  
our total loans grew to $1.420 billion at the end of the first quarter of 2005, representing an increase of 3.77%, from $1.369 million at the end of 2004;
 
·  
our total deposits grew to $1.446 billion at the end of the first quarter of 2005, representing an increase of 2.63%, from $1.409 million at the end of 2004;
 
·  
our total revenue grew to $32.7 million in the first quarter of 2005, representing an increase of 58.52%, from $20.6 million in the same period of 2004; and
 
·  
our net income grew to $4.8 million in the first quarter of 2005, representing an increase of 104.99%, from $2.3 million in the same period of 2004.
 
These items, as well as other factors, contributed to the increase in net income for the first quarter of 2005 to $4.8 million from $2.3 million for the same period in 2004, or $0.23 per common share as compared to $0.16 per common share for the same period in 2004, assuming dilution, and are discussed in further detail throughout this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of this Quarterly Report on Form 10-Q.
 
19
 
Critical Accounting Policies
 
This discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities at the date of our financial statements. Actual results may differ from these estimates under different assumptions or conditions. The following is a description of our significant accounting policies used in the preparation of the accompanying consolidated financial statements.
 
Loans and Allowance for Loan and Lease Losses
 
Loans that management has the intent and ability to hold for the foreseeable future, or until maturity or payoff, are reported at their outstanding unpaid principal balances adjusted by any charge-offs, unearned finance charges, allowance for loan and lease losses, and net deferred nonrefundable fees or costs on origination. The allowance for loan and lease losses is an estimate to provide for probable collection losses in our loan and lease portfolio. Losses are charged and recoveries are credited to the allowance account at the time a loss is incurred or a recovery is received. The allowance for loan and lease losses amounted to $18.0 million and $9.9 million as of March 31, 2005 and March 31, 2004, respectively. Losses charged to the allowance amounted to $3.0 million for the three months ended March 31, 2005 compared to $1.3 million for the same period in 2004. Recoveries were credited to the allowance in the amounts of $674,000 and $312,000 for those same periods, respectively.
 
We follow a consistent procedural discipline and account for loan and lease loss contingencies in accordance with Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, and SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan — Income Recognition and Disclosures.
 
To mitigate any difference between estimates and actual results relative to the determination of the allowance for loan and lease losses, our loan review department is specifically charged with reviewing monthly delinquency reports to determine if additional reserves are necessary. Delinquency reports and analysis of the allowance for loan and lease losses are also provided to senior management and the Board of Directors on a monthly basis.
 
The loan review department evaluates significant changes in delinquency with regard to a particular loan portfolio to determine the potential for continuing trends, and loss projections are estimated and adjustments are made to the historical loss factor applied to that portfolio in connection with the calculation of loss reserves. Portfolio performance is also monitored through the monthly calculation of the percentage of non-performing loans to the total portfolio outstanding. A significant change in this percentage may trigger a review of the portfolio and eventually lead to additional reserves. We also track the ratio of net charge-offs to total portfolio outstanding.
 
With the exception of the commercial loans pool and loans secured by real estate with a 60% or lower loan-to-value, loans that are more than 90 days delinquent result in an additional reserve. When commercial loans become 90 days delinquent, each is subjected to full review by the loan review officer including, but not limited to, a review of financial statements, repayment ability and collateral held. Depending on the findings, our allowance may be increased. In connection with this review, the loan review officer will determine what economic factors may have led to the change in the client’s ability to service the obligation, and this in turn may result in an additional review of a particular sector of the economy. For additional information relating to how each portion of the allowance for loan and lease losses is determined, see the section of this discussion and analysis captioned “Allowance for Loan and Lease Losses.”
 
We believe that our allowance for loan and lease losses is adequate; however, regulatory agencies, including the Commissioner of Financial Institutions of Puerto Rico and the FDIC, as an integral part of their examination process, periodically review our allowance for loan and lease losses and may from time to time require us to reclassify our loans and leases or make additional provisions to our allowance for loan and lease losses.
 
We classify loans as nonperforming when they become 90 days past due. Nonperforming loans amounted to $37.0 million, $40.5 million and $26.9 million as of March 31, 2005, December 31, 2004 and March 31, 2004, respectively.
 
20
 
Servicing Assets
 
We have no contracts to service loans for others, except for servicing rights retained on lease sales. The total cost of loans or leases to be sold with servicing assets retained is allocated to the servicing assets and the loans or leases (without the servicing assets), based on their relative fair values. Servicing assets are amortized in proportion to, and over the period of, estimated net servicing income. In addition, we assess capitalized servicing assets for impairment based on the fair value of those assets.
 
To estimate the fair value of servicing assets we consider prices for similar assets and the present value of expected future cash flows associated with the servicing assets calculated using assumptions that market participants would use in estimating future servicing income and expense, including discount rates, anticipated prepayment and credit loss rates. For purposes of evaluating and measuring impairment of capitalized servicing assets, we evaluate separately servicing retained for each loan portfolio sold. The amount of impairment recognized, if any, is the amount by which the capitalized servicing assets exceed its estimated fair value. Impairment is recognized through a valuation allowance with changes included in net income for the period in which the change occurs. The key assumptions we utilized in measuring the servicing assets at the dates the sales were completed during the year ended December 31, 2004, were as follows: prepayment rate of 15.12%; weighted average live (in years) of 3.70; and a discount rate of 8.68%. Impairment analyses were performed in December 2004 by an independent third party and it was determined that there was an impairment, which resulted in an adjustment of approximately $214,000 at December 31, 2004 on the servicing assets acquired from BankTrust. Servicing assets are included as part of other assets in the balance sheets. Servicing assets recorded amounted to $3.6 million as of March 31, 2005 and December 31, 2004, and $2.6 million as of March 31, 2004. Servicing assets in the first three months of 2005 and during 2004 increased as a result of sale of lease financing contracts made during the periods and our acquisition of The Bank & Trust of Puerto Rico on May 3, 2004.
 
Other Real Estate Owned and Repossessed Assets
 
Other real estate owned, or OREO, and repossessed assets, normally obtained through foreclosure or other workout situations, are initially recorded at the lower of fair value or book value at the date of foreclosure, establishing a new cost basis. Any resulting loss is charged to the allowance for loan and lease losses. An appraisal of other real estate properties and valuations of repossessed assets are made periodically after its acquisition, and comparison between the appraised value and the carrying value is performed. Additional declines in value after acquisition, if any, are charged to current operations. Other real estate owned amounted to $3.6 million, $2.9 million, and $2.8 million as of March 31, 2005, December 31, 2004 and March 31, 2004, respectively. Other repossessed assets amounted to $5.5 million, $3.6 million and $5.0 million for those same periods, respectively.
 
The loss on the sale of repossessed vehicles as a percentage of the lease balance at the date of repossession was 17.2% and 14.8% for the first quarters of 2005 and 2004, respectively. For the quarter ended March 31, 2005, the total loss on the sale of repossessed equipment was $127,000. We did not sell any repossessed equipment during the first quarter of 2004. For the first three months of 2005, approximately 77.23% of our lease financing contracts originations were for new automobiles, approximately 21.47% were for used automobiles and the remaining 1.30% consisted primarily of construction and medical equipment leases.
 
When our inventory of repossessed assets is larger, we are more aggressive in our disposition efforts. This strategy permits us to move inventory at a faster pace, but increases our losses per unit. The annualized ratio of loss on the sale of repossessed vehicles and equipment to our leasing portfolio balance increased to 1.07% at March 31, 2005, compared to 0.68% at December 31, 2004. The increase in the ratio of loss on the sale of repossessed vehicles and equipment to our leasing portfolio balance was due to the sale of damaged equipment previously charged-off and the sale of vehicles in bad condition as part of our strategy to aggressively dispose of deteriorated units.  
 
As of March 31, 2005, the total loss on the sale of repossessed boats was $309,000. We did not have any marine loans as of March 31, 2004. We acquired marine loans totaling $51.4 million on May 3, 2004 as a result of our acquisition of The Bank & Trust of Puerto Rico. The boat financing portfolio amounted to $45.2 million as of March 31, 2005.
 
21
 
Results of Operations as of and for the Three Months Ended March 31, 2005 and 2004
 
Net Interest Income and Net Interest Margin
 
Net interest income is the difference between interest income, principally from loan, lease and investment securities portfolios, and interest expense, principally on customer deposits and borrowings. Net interest income is our principal source of earnings. Changes in net interest income result from changes in volume, spread and margin. Volume refers to the average dollar level of interest-earning assets and interest-bearing liabilities. Spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Margin refers to net interest income divided by average interest-earning assets, and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.
 
Net interest income increased by 71.38%, or $7.6 million, to $18.3 million in the first quarter of 2005 from $10.7 million in the same period of 2004. Our net interest margin and net interest spread also increased to 3.75% and 3.38% from 3.43% and 3.14%, respectively. These increases resulted from the combined effect on net increases in volumes and rates, but mainly to increased volumes as shown on table on page 24.
 
 Total interest income increased by 67.06% to $37.8 million for the first quarter of 2005, as compared to $19.0 million for the same period in 2004. This increase resulted primarily from increases in average interest-earning assets and also by increased yield experienced during the second semester of 2004 and the first three months ended March 31, 2005. Our average interest-earning assets increased by $734.4 million (56.88%) to $2.0 billion in the first quarter of 2005, as compared to $1.3 billion for the same period in the prior year. Average net loans increased by $482.4 million (52.83%) to $1.4 billion in the first quarter of 2005, as compared to $913.2 million for the same period in the prior year. During the first month period ended March 31, 2005, we benefited from the higher average balances of loans, the assets acquired from BankTrust, and the higher interest rate environment.
 
Total interest expense increased by 61.55% to $13.5 million in the first quarter of 2005, compared to $8.3 million in the same period of 2004. These increases resulted from the combined effect of higher volumes of interest-bearing liabilities and the higher cost of funds on other borrowings that we experienced during the second semester of 2004 and the first quarter of 2005. Average interest-bearing liabilities increased by 53.94% to $1.8 billion in the first quarter of 2005, compared to $1.2 million in the same period of 2004. These increases resulted from organic growth as well as from the acquisition of BankTrust in May 2004. The average interest rate we paid for interest-bearing liabilities for the first quarter of 2005 increased to 3.29% from 3.02% for same period in 2004.
 
The following tables set forth, for the periods indicated, our average balances of assets, liabilities and stockholders’ equity, in addition to the major components of net interest income and our net interest margin. Net loans and leases shown on these tables include nonaccrual loans although interest accrued but not collected on these loans is placed in nonaccrual status and reversed against interest income.
 
22
 
     
Three Months Ended March 31, 
  
     
2005 
    
2004 
  
     
Average Balance 
    
Interest 
    
Average Rate/ Yield(1) 
    
Average Balance 
    
Interest 
    
Average Rate/ Yield(1) 
  
     
(Dollars in thousands) 
  
                                       
ASSETS:
    
                               
Interest-earning assets:
                                      
Net loans and leases(2)
  
$
1,395,580
  
$
26,728
    
7.72
%
 $
913,181
  
$
16,751
    
7.37
%
Securities of U.S. government agencies
    
549,415
    
4,375
    
4.43
    
313,667
    
2,008
    
3.55
  
Other investment securities
    
33,772
    
339
    
5.45
    
10,316
    
71
    
3.83
  
Puerto Rico government obligations
    
9,496
    
94
    
5.50
    
4,578
    
48
    
5.83
  
Securities purchased under agreements to resell and federal funds sold
    
29,452
    
184
    
2.57
    
38,136
    
99
    
1.04
  
Interest-earning deposits
    
7,935
    
33
    
1.66
    
11,336
    
29
    
1.02
  
Total interest-earning assets
  
$
2,025,650
  
$
31,753
    
6.67
%
 $
1,291,214
  
$
19,006
    
6.16
%
Total noninterest-earning assets
    
76,610
                
54,506
              
TOTAL ASSETS
  
$
2,102,260
              
 $
1,345,720
              
                                       
                           
LIABILITIES AND STOCKHOLDERS’ EQUITY:
                                      
Interest-bearing liabilities:
                                      
Money market deposits
  
$
76,946
  
$
409
    
2.15
%
 $
52,118
  
$
309
    
2.37
%
NOW deposits
    
49,400
    
224
    
1.82
    
27,612
    
115
    
1.68
  
Savings deposits
    
277,048
    
1,551
    
2.24
    
250,174
    
1,668
    
2.67
  
Time certificates of deposit in denominations of $100,000 or more
    
711,953
    
6,268
    
3.66
    
412,643
    
3,705
    
3.85
  
Other time deposits
    
179,257
    
1,316
    
2.94
    
166,490
    
1,237
    
2.97
  
Other borrowings
    
504,704
    
3,717
    
3.79
    
259,805
    
1,314
    
2.35
  
Total interest-bearing liabilities
  
$
1,799,308
  
$
13,485
    
3.29
%
 $
1,168,842
  
$
8,348
    
3.02
%
Noninterest-bearing liabilities:
                                      
Noninterest-bearing deposits
    
126,025
                
100,537
              
Other liabilities
    
17,132
                
9,707
              
Total noninterest-bearing liabilities
    
143,157
                
110,244
              
STOCKHOLDERS’ EQUITY
    
159,795
                
66,634
              
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
  
$
2,102,260
              
$
1,345,720
              
Net interest income(3)
        
$
18,268
              
$
10,658
        
Net interest spread(4)
                
3.38
%
              
3.14
%
Net interest margin(5)
                
3.75
%
              
3.43
%

__________
(1) Yields on tax-exempt securities, loans and leases are calculated on a fully taxable equivalent basis assuming a 39% tax rate.
 
(2) Loan fees (costs) have been included in the calculation of interest income. Loan fees were approximately $1.9 million and $1.6 million for the first quarters ended March 31, 2005 and 2004, respectively. Loans are net of the allowance for loan and lease losses, deferred fees, unearned income, and related direct costs.
 
(3) Net interest income on a tax equivalent basis was $19.0 million and $11.1 million for the first quarters ended March 31, 2005 and 2004, respectively.
 
(4) Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities on a fully taxable equivalent basis.
 
(5) Represents net interest income on a fully taxable equivalent basis as a percentage of average interest-earning assets.

23

The following table sets forth, for the periods indicated, the dollar amount of changes in interest earned and paid for interest-earning assets and interest-bearing liabilities and the amount of change attributable to changes in average daily balances (volume) or changes in average daily interest rates (rate). All changes in interest owed and paid for interest-earning assets and interest-bearing liabilities are attributable to either volume or rate. The impact of changes in the mix of interest-earning assets and interest-bearing liabilities is reflected in our net interest income.
 
   
Three Months Ended March 31,
2005 Over 2004
Increases/(Decreases)
Due to Change in
  
 
    
Volume 
    
Rate
    
Net
  
 
  
(In thousands) 
INTEREST EARNED ON:
                    
Net loans(1)
  
$
8,849
  
$
1,128
  
$
9,977
  
Securities of U.S. government agencies
    
1,509
    
858
    
2,367
  
Other investment securities
    
161
    
107
    
268
  
Puerto Rico government obligations
    
52
    
(6
)
  
46
  
Securities purchased under agreements to resell and federal funds sold
    
(23
)
  
108
    
85
  
Interest-earning deposits
    
(9
)
  
13
    
4
  
Total interest-earning assets
  
$
10,539
  
$
2,208
  
$
12,747
  
                     
INTEREST PAID ON:
                    
Money market deposits
  
$
147
  
$
(47
)
$
100
  
NOW deposits
    
91
    
18
    
109
  
Savings deposits
    
179
    
(296
)
  
(117
)
Time certificates of deposit in denominations of $100,000 or more
    
2,687
    
(124
)
  
2,563
  
Other time deposits
    
95
    
(16
)
  
79
  
Other borrowings
    
1,239
    
1,164
    
2,403
  
Total interest-bearing liabilities
  
$
4,438
  
$
699
  
$
5,137
  
Net interest income
  
$
6,101
  
$
1,509
  
$
7,610
  
__________
(1) Loan fees (costs) have been included in the calculation of interest income. Loan fees were approximately $1.9 million and $1.6 million for the three months ended March 31, 2005 and 2004, respectively. Loans are net of the allowance for loan and lease losses, deferred fees, unearned income, and related direct costs.
 
Provision for Loan and Lease Losses
 
We determine a provision for loan and lease losses that we consider sufficient to maintain an allowance to absorb probable losses inherent in our portfolio as of the balance sheet date. For additional information concerning this determination, see the section of this discussion and analysis captioned “Allowance for Loan and Lease Losses.”
 
In the first quarter of 2005, our provision for loan and lease losses decreased to $1.3 million from $1.5 million for the same period in 2004. This decrease in our provision was a direct result of the periodic evaluation of the allowance for possible loan and lease losses, considering net charge-offs, delinquencies and related experience.
 
We believe existing reserve levels are appropriate. While our allowance for loan and lease losses is established in different portfolio components, we maintain an allowance that we believe is sufficient to absorb all credit losses inherent in our portfolio.
 
In order to maintain an adequate level of our allowance for loan and lease losses, we monitor our portfolio performance on a monthly basis and determine the additional provision for loan and lease losses. Risk levels and losses in our commercial loan portfolio and our lease portfolio have been fairly constant. Individual credits that are less than satisfactory or delinquent are reviewed on an ongoing basis to determine whether additional provisions are necessary. For more detail on net charge-offs please refer to the “Allowance for Loan and Lease Losses” section herein.
 
24
 
Noninterest Income
 
The following tables set forth the various components of our noninterest income for the periods indicated:
 
Three Months Ended March 31, 
  
Three Months Ended March 31,
     
2005
    
2004 
  
 
    
(Amount)
    
(%)
 
  
(Amount)
 
  
(%)
 
 
  
(Dollars in thousands) 
Service charges and other fees
  
$
1,973
    
218.9
%
$
1,637
    
102.8
%
Loss on sale of non-hedging derivatives, net
    
(1,075
)
  
(119.3
)
  
—
    
—
  
Gain on sale of loans and leases, net
    
426
    
47.3
    
—
    
—
  
Loss on sale of securities, net
    
(230
)
  
(25.5
)
  
—
    
—
  
Loss on sale of repossessed assets and on disposition of other assets, net
    
(193
)
  
(21.4
)
  
(44
)
  
(2.8
)
Total noninterest income
  
$
901
    
100.0
%
$
1,593
    
100.0
%
 
Our total noninterest income for the first quarter of 2005 was $901,000, representing a 43.44% decrease from $1.6 million for the same period in 2004. Noninterest income represented approximately 0.04% and 0.12% of average assets as of March 31, 2005 and 2004, respectively. Decrease is explained as follows:
 
As a result of our efforts to diversify our revenue sources, we currently earn noninterest income from various sources. Our largest noninterest income source is service charges, primarily on deposit accounts, representing 218.9% and 102.8% of total noninterest income for the first quarter of 2005 and 2004, respectively. These increases were primarily due to an increase in our number of transactional and savings accounts resulting from organic growth as well as from the acquisition of BankTrust in May 2004.
 
Other component of noninterest income is the net loss on sale of non-hedging derivatives. Net noninterest income reflects a $1.1 million charge to earnings in the first quarter of 2005 for net losses on non-hedging derivatives on which hedge accounting had been discontinued, including a $1.3 million loss related to cash-flow hedges (such derivatives were subsequently terminated in April 2005 resulting in a $136,000 gain), and a $267,000 gain related to fair-value hedges. In April 2005, we re-designated all remaining derivatives as fair-value hedges. The derivatives were assumed in connection with the acquisition of BankTrust in May 2004.
 
Gain on the sale of loans and leases, net was the second largest source of noninterest income during the first quarter of 2005. For the first quarter of 2005, gain on sale of loans and leases was $426,000. There were no sale of loans during the first quarter of 2004. This source of noninterest income is derived primarily from the sale of lease financing contracts and mortgage loans. In February 2005, we sold lease financing contracts carrying values of $14.9 million. We retained servicing responsibilities for the lease financing contracts sold. We surrendered control of the lease financing receivables, as defined by SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, and accounted for this transaction as sale, recognizing a net gain of approximately $365,000. While the estimated losses on the limited recourse obligations assumed in the sale of our lease financing contracts is not significant, we established an allowance of $106,000 on March 23, 2005 and have included such estimate in the other liabilities section of our balance sheet as of March 31, 2005. Also, during the first quarter of 2005, we sold $5.1 million in mortgage loans to other financial institutions. We did not retain the servicing rights on these mortgage loans and we accounted for this transaction as a sale, resulting in a gain of approximately $61,000.
 
During the quarter ended March 31, 2005, we recognized a $230,000 loss on sale of $40.0 million in U.S. Treasury obligations available for sale, which were sold in an effort to improve the yields of the available for sale securities portfolio. No securities were sold during the first quarter of 2004.
 
Our final component of noninterest income for the first quarter of 2005 and 2004 is the net loss on the sale of our repossessed assets and other assets. During first quarter of 2005, we experienced a net loss in this component of $193,000, as compared to a net loss of $44,000 during the same period in 2004. This mainly resulted from a loss on the sale of repossessed automobiles and equipment of $193,000 and $51,000 during the first quarter of 2005 and 2004, respectively. This increase in net loss was mainly due to the sale of damaged autos during the quarter ended on March 31, 2005. Also, as our volume of lease financings has increased, in order to avoid building our inventory of repossessed automobiles, we have been more aggressive in our disposition efforts, resulting in additional unanticipated losses.
 
25
 
Noninterest Expense
 
The following tables set forth a summary of noninterest expenses for the periods indicated:
 
 
  
Three Months Ended March 31, 
     
2005 
    
2004 
  
 
    
(Amount) 
    
(%)
 
  
(Amount)
 
  
(%)
 
 
  
(Dollars in thousands) 
Salaries and employee benefits
  
$
5,740
    
52.9
%
$
4,004
    
54.3
%
Occupancy and equipment
    
2,051
    
19.0
    
1,532
    
20.8
  
Professional services, including directors’ fees
    
646
    
6.0
    
361
    
4.9
  
Office supplies
    
338
    
3.1
    
220
    
3.0
  
Other real estate owned and other repossessed assets expenses
    
237
    
2.2
    
56
    
0.8
  
Promotion and advertising
    
133
    
1.2
    
116
    
1.6
  
Lease expenses
    
147
    
1.4
    
67
    
0.9
  
Insurance
    
294
    
2.7
    
149
    
2.0
  
Municipal and other taxes
    
429
    
4.0
    
196
    
2.7
  
Commissions and service fees credit and debit cards
    
353
    
3.3
    
273
    
3.7
  
Other noninterest expense
    
453
    
4.2
    
389
    
5.3
  
       Total noninterest expense
  
$
10,821
    
100.0
%
$
7,363
    
100.0
%
 
Our total noninterest expense increased to $10.8 million in the first quarter of 2005, as compared to $7.4 million for the same period in 2004. This represents an increase in noninterest expense of 46.96%. This increase can be attributed to the expanded personnel and occupancy costs associated with our business growth, our acquisition of BankTrust, and the recent opening of new branch offices. Our expansion of various groups, including EuroLease, our construction lending activities and our trust and wealth management group, also contributed to the increase in our total noninterest expense. Due to our continuing efforts to minimize noninterest expense, noninterest expenses as a percentage of average assets decreased to 0.51% in the first quarter of 2005, as compared to 0.55% for the same period in 2004. We believe that our efforts to expand without comparative increases in our number of employees have improved our operational efficiency. Our efficiency improvement is evidenced by the decrease in our efficiency ratio to 54.37% in the first quarter of 2005, as compared to 58.17% for the same period in 2004. The efficiency ratio is determined by dividing total noninterest expense by an amount equal to net interest income (fully taxable equivalent) plus noninterest income.
 
We anticipate that the overall volume of our noninterest expense will continue to increase as we grow. However, we remain committed to controlling costs and efficiency and expect to moderate these increases relative to our revenue growth.
 
Salaries and employee benefits totaled $5.7 million for the first quarter of 2005, as compared to $4.0 million for the same period in 2004, representing an increase of 43.36% for the comparable period. Despite the new branch openings and significant asset growth in the past year, primarily due to our acquisition of BankTrust in May 2004, we have limited full-time employee growth by making efficient use of existing employees. We had 467 full-time equivalent employees as of March 31, 2005, compared with 367 as of March 31, 2004. Our volume of assets per employee increased to $4.5 million and $3.9 million for those same periods.
 
Occupancy and equipment expenses totaled $2.1 million for the first quarter of 2005 as compared to $1.5 million for the same period in 2004, representing an increase of 33.88% for the comparable period. This increase is attributable primarily to the expansion of our branch network and franchise as well as the acquisition of BankTrust in May 2004.
 
Professional and directors’ fees were $646,000 and $361,000 or 6.0% and 4.9% of total noninterest expenses, for the first quarter of 2005 and 2004, respectively. This increase is attributable primarily to the growth of our business and also to legal, audit, consulting and professional fees related to becoming a publicly-traded company and our other actions to implement our strategic plan.
 
Our expenses related to OREO and repossessed assets were $237,000 and $56,000 or 2.2% and 0.8% of total noninterest expenses, for the first quarter of 2005 and 2004, respectively. This increase is attributable primarily to the growth of our loan and lease portfolio, and in particular, our lease financing portfolio. Repossessed assets are initially recorded at the lower of fair value or book value upon repossession and resulting losses are charged to the allowance for loan and lease losses. These assets are then periodically evaluated and recorded at fair value. Any subsequent decline in the fair value is charged to current operations.
 
26
 
Municipal and other taxes increased to $429,000 for the first quarter of 2005 as compared to $196,000 for the same period in 2004. These increases are directly attributable to our asset growth.
 
Commissions and service fees on credit and debit cards increased to $353,000 for the first quarter of 2005 as compared to $273,000 for the same period in 2004. This increase is attributable primarily to the increase in the size of our commercial loan portfolio, which provides us with merchant point-of-sale business.
 
Other noninterest expenses also increased for the first quarter of 2005. This increase was related in part to our asset growth over these periods. Due in part to management’s commitment to overhead control, the expense increase was significantly outpaced by our revenue growth rate.
 
We also expect our noninterest expense to increase as a result of our becoming a publicly-traded company. Specifically, we expect increases in audit fees, legal fees associated with public reporting, printing costs, proxy solicitation costs, and officers’ insurance cost and other expenses generally associated with publicly-traded companies.
 
Provision for Income Taxes
 
Puerto Rico income tax law does not provide for the filing of a consolidated tax return; therefore, the income tax expense reflected in our consolidated income statement is the sum of our income tax expense and the income tax expenses of our individual subsidiaries. Our revenues are generally not subject to U.S. federal income tax.
 
Income tax expense is the sum of two components: current tax expense and deferred tax expense (benefit). Current tax expense is calculated by applying the statutory tax rate to taxable income. The deferred tax expense (benefit) reflects the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Deferred income tax assets and liabilities represent the tax effects, based on current tax law, of future deductible or taxable amounts attributable to events that have been recognized in our financial statements.
 
For the quarter ended March 31, 2005, we recorded a $2.3 million income tax expense, compared to $1.1 million for the same period in 2004. Although the net book income before taxes increased by 109.5% to $7.1 million at March 31, 2005 from $3.4 million as of March 31, 2004, our current income tax expense decreased by 25.0% to $703,000 from $937,000 for those same periods. The increase in our net book income before taxes was mainly offset by the net operating losses acquired from Banco Financiero and BankTrust, which are further discussed below. However, when calculating the taxable income, the increase in the net book income before taxes attributable to the Eurobank’s operations was reduced mainly because of the increase in the exempt income as a percentage of book net income before taxes and the reduction in the allowance for loan and lease losses. The allowance for loans and lease losses decreased to $18.0 million at March 31, 2005 from $19.0 million at December 31, 2004, resulting in a deduction for the quarter ended on March 31, 2005. Furthermore, our income tax provision is lower than a provision based on the statutory tax rate applicable to Eurobank, which is 39.0%, because we have interest income from certain investments that is exempt from Puerto Rico income tax. Exempt interest relates mostly to interest earned on securities held by EBS Overseas, Eurobank’s international banking entity subsidiary.
 
Our deferred tax expense increased to $1.6 million at March 31, 2005, compared to $124,000 at March 31, 2004. The increase in our deferred tax expense is due to the increase in the deferred tax assets, which increased by $7.4 million to $10.8 million at March 31, 2005 from $3.4 million at March 31, 2004. This increase was mainly due to the increase in the provision for loan and lease losses, which increased to $18.0 million at March 31, 2005 from $9.9 million in March 31, 2004 and because of the net operating losses acquired from BankTrust in May 2004.
 
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. In order to fully realize the deferred tax asset that resulted from our acquisition of Banco Financiero and BankTrust, we will need to generate future taxable income of approximately $4.3 million and $11.8 million related to their operations, respectively, prior to the expiration of the net operating loss carryforwards through years 2006 and 2011, respectively. Such operations yielded approximately $3.6 million of taxable income during the first quarter of 2005 and considering economies of scale to be achieved from the mergers and projected future taxable income over the periods in which the deferred tax assets are deductible, we believe it is more likely than not that the benefits of these deductible differences at March 31, 2005 will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.
 
27
 
Financial Condition
 
Our total assets as of March 31, 2005 were $2.120 billion, compared to $2.103 billion as of December 31, 2004. The increase in our total assets during the first three months of 2005 were primarily the result of growth in loans and leases from current operations.
 
Our total deposits increased to $1.446 billion as of March 31, 2005, compared to $1.409 million as of December 31, 2004. The increase in deposits during the first three months of 2005 was due to the organic growth of the Bank.
 
As of March 31, 2005, our stockholders’ equity was $159.6 million, compared to $158.3 million as of December 31, 2004. In addition to earnings from operations, our stockholders’ equity was also impacted by accumulated other comprehensive losses of $6.6 million and $3.2 million during the first three months of 2005 and the year 2004, respectively.
 
Short-Term Investments and Interest-bearing Deposits in Other Financial Institutions
 
We sell federal funds, purchase securities under agreements to resell, and deposit funds in interest-bearing accounts in other financial institutions to help meet liquidity requirements and provide temporary holdings until the funds can be otherwise deployed or invested. We had $8.4 million and $5.7 million in interest-bearing deposits in other financial institutions as of March 31, 2005 and December 31, 2004, respectively. We had $25.5 million and $42.8 in purchased securities under agreements to resell as of March 31, 2005 and December 31, 2004, respectively.
 
Investment Securities
 
Our investment portfolio primarily serves as a source of interest income and, secondarily, as a source of liquidity and a management tool for our interest rate sensitivity. We manage our investment portfolio according to a written investment policy implemented by our Asset/Liability Management Committee. Our investment policy is reviewed at least annually by our Board of Directors. Investment balances, including cash equivalents and interest-bearing deposits in other financial institutions, are subject to change over time based on our asset/liability funding needs and our interest rate risk management objectives. Our liquidity levels take into consideration anticipated future cash flows and all available sources of credits and are maintained at levels management believes are appropriate to assure future flexibility in meeting our anticipated funding needs.
 
Our investment portfolio consists of securities we intend to hold until maturity, or “held-to-maturity securities,” and all other securities are classified as “available-for-sale.” The carrying values of our available-for-sale securities are adjusted for unrealized gain or loss as a valuation allowance, and any gain or loss is reported on an after-tax basis as a component of other comprehensive income.
 
28

The following table presents the composition, book value and fair value of our investment portfolio by major category as of the dates indicated:
 
     
Available-for-Sale 
    
Held-to-Maturity 
    
Total 
  
 
    
Amortized
Cost 
    
Estimated
Fair Value
    
Amortized
Cost
    
Estimated
Fair Value
    
Amortized
Cost
    
Estimated
Fair Value
  
 
  
(Dollars in thousands) 
March 31, 2005:
                                      
U.S. treasury securities
  
$
44,925
  
$
44,605
  
$
—
  
$
—
  
$
44,925
  
$
44,605
  
U.S. government agencies obligations
    
97,619
    
96,002
    
4,563
    
4,485
    
102,182
    
100,487
  
Collateralized mortgage obligations
    
329,251
    
324,933
    
36,177
    
35,799
    
365,428
    
360,732
  
Mortgage-backed securities
    
60,097
    
59,811
    
7,322
    
7,220
    
67,419
    
67,031
  
State and municipal obligations
    
9,470
    
9,452
    
—
    
—
    
9,470
    
9,452
  
Total
  
$
541,362
  
$
534,803
  
$
48,062
  
$
47,504
  
$
589,424
  
$
582,307
  
                                       
December 31, 2004:
                                      
U.S. treasury securities
  
$
84,882
  
$
84,392
  
$
—
  
$
—
  
$
84,882
  
$
84,392
  
U.S. government agencies obligations
    
89,376
    
88,799
    
4,813
    
4,775
    
94,189
    
93,574
  
Collateralized mortgage obligations
    
303,016
    
301,070
    
37,128
    
36,991
    
340,144
    
338,061
  
Mortgage-backed securities
    
71,304
    
71,707
    
7,563
    
7,540
    
78,867
    
79,247
  
State and municipal obligations
    
9,477
    
9,514
    
—
    
—
    
9,477
    
9,514
  
Total
  
$
558,055
  
$
555,482
  
$
49,504
  
$
49,306
  
$
607,559
  
$
604,788
  
 
During the first quarter of 2005, our investment portfolio decreased by approximately $22.3 million to $590.0 million from approximately $612.3 million as of December 31, 2004. This decrease was primarily due to the net effect of a $40.0 million sale of US Treasury obligations maturing during August and September of 2005, the monthly principal prepayments for approximately $26.6 million of mortgage-backed securities, and the purchase of $8.2 million FHLB obligations and $41.3 million of mortgage-backed securities. During the past few years, we have positioned our investment portfolio for an increase in interest rates by purchasing mostly investments with maturities or estimated maturities between 1½ to 4 years. During the first quarter of 2005, we have seen higher interest in the short term of the curve and we have been able to reinvest at higher yields and for maturities or estimated maturities from 2 years to 4½ years. As of March 31, 2005, after aforementioned transactions, the estimated average maturity was approximately 3.73 years and the average yield was approximately 4.68% compared to the estimated average maturity of approximately 2.64 years and the average yield of approximately 4.15% as of December 31, 2004. As of March 31, 2005, investment securities having a carrying value of approximately $484.9 million were pledged to secure borrowings and deposits of public funds and to comply with other pledging requirements.

29

Investment Portfolio — Maturity and Yields
 
The following table summarizes the contractual maturity of investment securities held in our investment portfolio and their weighted average yields:
 
     
Three Months Ended March 31, 2005 
  
     
Within  One Year 
    
After One but
Within Five Years
    
After Five but
Within Ten Years
    
After Ten Years 
    
Total 
  
     
Amount
    
Yield 
    
Amount 
    
Yield 
    
Amount 
    
Yield 
    
Amount 
    
Yield 
    
Amount 
    
Yield 
  
     
(Dollars in thousands) 
  
Investments available-for-sale: (1)(2)
                                                              
U.S. treasury obligations
  
$
44,606
    
1.76
%
$
—
    
—
%
$
—
    
—
%
$
—
    
—
%
$
44,606
    
1.76
%
U.S. government agencies obligations
    
42,653
    
3.01
    
53,349
    
3.62
    
—
    
—
    
—
    
—
    
96,002
    
3.35
  
Mortgage backed securities(3)
    
25,695
    
4.27
    
17,192
    
4.62
    
—
    
—
    
—
    
—
    
42,887
    
4.41
  
Collateral mortgage obligations(3)
    
—
    
—
    
—
    
—
    
47,564
    
5.03
    
294,292
    
5.13
    
341,856
    
5.11
  
State & political subdivisions
    
1,505
    
4.75
    
6,240
    
3.70
    
—
    
—
    
1,707
    
6.24
    
9,452
    
4.32
  
Other debt securities
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
  
Total investments available-for-sale
  
$
114,459
    
2.83
%
$
76,781
    
3.85
%
$
47,564
    
5.03
%
$
295,999
    
5.13
%
$
534,803
    
4.45
%
                                                               
Investments held-to-maturity: (2)
                                                              
U.S. treasury obligations
  
$
—
    
—
%
$
—
    
—
%
$
4,563
    
3.84
%
$
—
    
—
%
$
4,563
    
3.84
%
U.S. government agencies obligations
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
  
Mortgage backed securities(3)
    
—
    
—
    
—
    
—
    
—
    
—
    
7,322
    
5.50
    
7,322
    
5.50
  
Collateral mortgage obligations(3)
    
—
    
—
    
—
    
—
    
—
    
—
    
36,177
    
4.84
    
36,177
    
4.84
  
State & political subdivisions
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
  
Other debt securities
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
    
—
  
Total investments held-to-maturity
  
$
—
    
—
%
$
—
    
—
%
$
4,563
    
3.84
%
$
43,499
    
4.95
%
$
48,062
    
4.85
%
                                                               
Other Investments:
                                                              
FHLB stock
    
7,127
    
3.05
%
  
—
    
—
%
  
—
    
—
%
  
—
    
—
%
  
7,127
    
3.05
%
Investment in statutory trust
    
—
    
—
    
—
    
—
    
—
    
—
    
1,385
    
6.51
    
1,385
    
6.51
  
Total other investments
  
$
7,127
    
3.05
%
$
—
    
—
%
$
—
    
—
%
$
1,385
    
6.51
%
$
8,512
    
3.61
%
Total investments
  
$
121,586
    
2.84
%
$
76,781
    
3.85
%
$
52,127
    
4.93
%
$
340,883
    
5.12
%
$
591,377
    
4.47
%
__________
(1) Based on estimated fair value.
 
(2) Almost all of our income from investments in available-for-sale securities is tax exempt because 99.3% of these securities are held in our IBE. The yields shown in the above table are not calculated on a fully taxable equivalent basis.
 
(3) Maturities of mortgage-backed securities and collateralized mortgage obligations, or CMOs, are based on anticipated lives of the underlying mortgages, not contractual maturities. CMO maturities are based on cash flow (or payment) windows derived from broker market consensus.
 
Other Earning Assets
 
For various business purposes, we make investments in earning assets other than the interest-earning securities discussed above. As of March 31, 2005, our investment in other earning assets included $7.1 million in FHLB stock and $1.4 million equity in our statutory trusts. The following table presents the balances of other earning assets as of the dates indicated:
 
     
As of March 31, 
    
As of December 31, 
  
     
2005 
    
2004
  
    Type
    
(In thousands) 
  
Statutory trusts
  
$
1,385
  
$
1,386
  
FHLB stock
    
7,127
    
7,330
  
Total
  
$
8,512
  
$
8,716
  
 
30

Loan and Lease Portfolio
 
Our primary source of income is interest on loans and leases. The following table presents the composition of our loan and lease portfolio by category as of the dates indicated, excluding loans held for sale secured by real estate amounting to $3.1 million and $2.7 million as of March 31, 2005 and December 31, 2004, respectively:
 
     
As of March 31, 
    
As of December 31, 
  
     
2005 
    
2004 
  
     
(In thousands) 
  
Real estate secured
  
$
546,133
  
$
516,542
  
Leases
    
465,992
    
459,251
  
Other commercial and industrial
    
258,327
    
243,603
  
Consumer
    
72,896
    
74,755
  
Real estate - construction
    
78,506
    
79,334
  
Other loans
    
7,588
    
6,134
  
Gross loans and leases
  
$
1,429,442
  
$
1,379,619
  
Plus: Deferred loan costs, net
    
6,734
    
6,480
  
Total loans, including deferred loan costs, net
  
$
1,436,176
  
$
1,386,099
  
Less: Unearned income
    
(1,105
)
  
(1,170
)
Total loans, net of unearned income
  
$
1,435,071
  
$
1,384,929
  
Less: Allowance for loan and lease losses
    
(17,966
)
  
(19,039
)
Loans, net
  
$
1,417,105
  
$
1,365,890
  
 
As of March 31, 2005 and December 31, 2004, our total loans and leases, net of unearned income, were $1.435 billion and $1.385 billion, respectively. The increase in our loan and lease volume during the three months ended March 31, 2005 resulted from the organic growth of our operations. Our total loans and leases, net of unearned income, as a percentage of total assets increased to 67.8% as of March 31, 2005 from 65.9% as of December 31, 2004.
 
Real estate secured loans, the largest component of our loan and lease portfolio, consist primarily of commercial real estate loans and/or commercial lines of credit that are extended to finance the purchase and/or improvement of commercial real estate and/or businesses thereon or for business working capital purposes. The properties may be either owner-occupied or for investment purposes. Our loan policy adheres to the real estate loan guidelines promulgated by the FDIC in 1993. The policy provides guidelines including, among other things, review of appraised value, limitation on loan-to-value ratio, and minimum cash flow requirements to service debt. Loans secured by real estate equaled $546.1 million and $516.5 million as of March 31, 2005 and December 31, 2004, respectively. The increase of our real estate loans is due to the organic growth of the Bank, as explained before. The percentage of our real estate secured loans in relation to our total loan and lease portfolio, increased to 38.2% for the three months ended March 31, 2005, as compared to 37.4% for the fiscal year ended 2004.
 
Lease financing contracts, the second largest component of our loan portfolio, consist of automobile and equipment leases made to individuals and corporate customers. In the last two years, we have deemphasized equipment leasing and focused on automobile leasing. For the first three months of 2005, approximately 77.23% of our lease financing contracts were for new automobiles, approximately 21.47% were for used automobiles and the remaining 1.30% consisted primarily of construction and medical equipment leases. The volume of our lease financing contracts increased to $466.0 million and $459.3 million as of March 31, 2005 and December 31, 2004, respectively. Lease financing contracts, as a percentage of total loans and leases were 32.6% as of March 31, 2005 and 33.3% at the end of 2004. During February 2005, we sold lease contracts with carrying values of $14.9 million to another financial institution, while retaining servicing responsibilities. The lease contracts sold during the first quarter of 2005 were sold on a limited recourse basis. The recourse is limited to a maximum of 5.0% of the outstanding aggregate principal balance at repossession date of all leases sold.
 
Other commercial and industrial loans include revolving lines of credit as well as term business loans. Other commercial and industrial loans increased to $258.3 million as of March 31, 2005 from $243.6 million as of December 31, 2004. The increase in other commercial and industrial loans in 2005 is attributable to the organic growth of the Bank. Other commercial and industrial loans as a percentage of total loans were 18.1% as of March 31, 2005, and 17.7% at the end of 2004.
 
Consumer loans have historically represented a small part of our total loan and lease portfolio. The majority of consumer loans consist of personal installment loans, credit cards, boat loans, and consumer lines of credit. We make consumer loans only to complement our commercial business, and these loans are not emphasized by our branch managers. Consumer loans decreased to $72.9 million as of March 31, 2005 from $74.8 million as of December 31, 2004. Consumer loans as a percentage of total loans and leases were 5.1% and 5.4% at March 31, 2005 and December 31, 2004.
 
Construction loans are not a significant part of our total loan portfolio. Construction loans totaled $78.5 million and $79.3 million as of March 31, 2005 and December 31, 2004. Construction loans as a percentage of total loans and leases were 5.5% and 5.8% as of March 31, 2005 and December 31, 2004, respectively.
 
31
 
Our loan terms vary according to loan type. Commercial term loans generally have maturities of three to five years, while we generally limit real estate loan maturities to five to eight years. Lines of credit, in general, are extended on an annual basis to businesses that need temporary working capital and/or import/export financing. The following table shows our maturity distribution of loans and leases, including loans held for sale of $3.1 million, as of March 31, 2005, excluding non-accrual loans amounting to $29.0 million. A significant part of our non-consumer loan portfolio is floating rate loans which comprise both commercial and industrial loans and commercial real estate loans. By contrast, residential mortgage loans originated by Eurobank are fixed rate. Residential mortgage loans are included in the real estate - secured category in the following table.
 
 
 
 
 
  
As of March 31, 2005 
           
Over 1 Year
through 5 Years 
    
Over 5 Years 
        
 
    
One Year
or Less(1) 
    
Fixed
Rate
    
Floating or Adjustable Rate
    
Fixed
Rate
    
Floating or Adjustable Rate
    
Total
  
 
  
(In thousands) 
Real estate — construction
  
$
83,639
  
$
-
  
$
7,871
  
$
648
  
$
2,555
  
$
94,713
  
Real estate — secured
    
146,581
    
69,259
    
231,030
    
55,238
    
15,330
    
517,438
  
Other commercial and industrial
    
183,433
    
18,357
    
41,601
    
7,315
    
1,383
    
252,089
  
Consumer
    
7,634
    
19,917
    
42
    
43,464
    
626
    
71,683
  
Leases
    
6,801
    
357,776
    
-
    
101,360
    
-
    
465,937
  
Other loans
    
7,279
    
-
    
-
    
-
    
-
    
7,279
  
Total
  
$
435,367
  
$
465,309
  
$
280,544
  
$
208,025
  
$
19,894
  
$
1,409,139
  
__________
(1) Maturities are based upon contract dates. Demand loans are included in the one year or less category and totaled $303.9 million as of March 31, 2005.
 
Nonperforming Loans, Leases and Assets
 
Nonperforming assets consist of loans and leases on nonaccrual status, loans 90 days or more past due and still accruing interest, loans that have been restructured resulting in a reduction or deferral of interest or principal, OREO, and other repossessed assets.
 

32

The following table sets forth the amounts of nonperforming assets (net of the portion guaranteed by the United States government) as of the dates indicated:
 
   
As of March 31,
  
As of December 31,
  
   
2005
  
2004
  
   
(Dollars in thousands)
  
Loans contractually past due 90 days or more but still accruing interest
  
$
7,974
  
$
8,365
  
Nonaccrual loans
    
29,024
    
32,168
  
Total nonperforming loans
    
36,998
    
40,533
  
Other real estate owned
    
3,628
    
2,875
  
Other repossessed assets
    
5,499
    
3,566
  
Total nonperforming assets
  
$
46,125
  
$
46,974
  
Nonperforming loans to total loans and leases
    
2.57
%
  
2.92
%
Nonperforming assets to total loans and leases plus repossessed property
    
3.19
    
3.37
  
Nonperforming assets to total assets
    
2.18
    
2.23
  
               
We continually review present and estimated future performance of the loans and leases within our portfolio and risk-rate such loans in accordance with a risk rating system. More specifically, we attempt to reduce the exposure to risks through: (1) reviewing each loan request and renewal individually; (2) utilizing a centralized approval system for loans in excess of $100,000 for secured commercial loans and $50,000 for unsecured commercial loans; (3) strictly adhering to written loan policies; and (4) conducting an independent credit review. In addition, loans based on short-term asset values are monitored on a monthly or quarterly basis. In general, we receive and review financial statements of borrowing customers on an ongoing basis during the term of the relationship and respond to any deterioration noted. We do not engage in sub-prime lending.
 
Loans are generally placed on nonaccrual status when they become 90 days past due, unless we believe the loan is adequately collateralized and we are in the process of collection. The nonrecognition of interest income on an accrual basis does not constitute forgiveness of the interest, and collection efforts are continuously pursued. Loans may be restructured by management when a borrower has experienced some change in financial status, resulting in an inability to meet the original repayment terms, and when we believe the borrower will eventually overcome financial difficulties and repay the loan in full.
 
All interest accrued but not collected for loans and leases that are placed on nonaccrual status or charged-off is reversed against interest income. The interest on these loans is accounted for on a cash basis or cost recovery method, until qualifying for return to accrual status.
 
The nonperforming loans and leases decreased to $37.0 million as of March 31, 2005 from $40.5 million as of December 31, 2004. At March 31, 2005, nonaccrual loans acquired from BankTrust amounted to $6.2 million, compared to $7.5 million as of December 31, 2004. The ratio of nonperforming loans and leases over total loans and leases decreased to 2.57% as of March 31, 2005, from 2.92% as of December 31, 2004.
 
We believe all loans and leases, with which we have serious doubts as to collectibility, are classified within the category of nonperforming loans and leases and are appropriately reserved.
 
OREO consists of properties acquired by foreclosure or similar means and that management intends to offer for sale. Other repossessed assets are comprised primarily of repossessed automobiles and equipment subject to lease contracts. OREO and repossessed assets are initially recorded at the lower of fair value or book value. Any resulting loss is charged to the allowance for loan and lease losses. An appraisal of OREO and valuations of repossessed assets are made periodically after a property is acquired, and a comparison between the appraised value and the carrying value is performed. Additional declines in value after acquisition, if any, are charged to current operations. Gains or losses on disposition of OREO and repossessed assets, and related operating income and maintenance expenses, are included in current operations. As of March 31, 2005, our OREO consisted of 14 properties with an aggregate value of $3.6 million, as compared to 12 properties with an aggregate value of $2.9 million as of December 31, 2004.
 
Other repossessed assets as of March 31, 2005 and December 31, 2004 were $5.5 million and $3.6 million, respectively. The increase in volume of repossessed assets during the first three months of 2005 was attributable to increases in volumes of our automobile lease originations. The increase in repossessed assets during the first quarter of 2005 was mainly related to a more aggressive approach by our collection department in order to reduce delinquency of our leasing portfolio. The delinquency of our leasing portfolio decreased to 4.79% at March 31, 2005 from 5.20% as of December 31, 2004.
 
33
 
Together with OREO, the ratio of nonperforming assets as a percentage of total loans and leases plus repossessed property decreased to 3.19% as of March 31, 2005 from 3.37% as of December 31, 2004.
 
Allowance for Loan and Lease Losses
 
We have established an allowance for loan and lease losses to provide for loans in our portfolio that may not be repaid in their entirety. The allowance is based on our regular, monthly assessments of the probable estimated losses inherent in the loan and lease portfolio. Our methodology for measuring the appropriate level of the allowance relies on several key elements, which include the formula described below, specific allowances for identified problem loans and portfolio segments and the unallocated allowance.
 
When analyzing the adequacy of our allowance, our portfolio is segmented into as many components as practical. Although the evaluation of the adequacy of our allowance focuses on loans and leases and pools of similar loans and leases, no part of our allowance is segregated for, or allocated to, any particular asset or group of assets. Our allowance is available to absorb all credit losses inherent in our portfolio.
 
Each component would normally have similar characteristics, such as classification, type of loan or lease, industry or collateral. As needed, we separately analyze the following components of our portfolio and provide for them in our allowance:
 
·  
credit quality;
 
·  
sufficiency of credit and collateral documentation;
 
·  
proper lien perfection;
 
·  
appropriate approval by the loan officer and the loan committees;
 
·  
adherence to any loan agreement covenants; and
 
·  
compliance with internal policies and procedures and laws and regulations.
 
The general portion of our allowance is calculated by applying loss factors to all categories of loans and leases outstanding in our portfolio. We use historic loss rates determined over a period of years. The resulting loss factors are then multiplied against the current period’s balance of loans outstanding to derive an estimated loss. We adjust the historical loss percentage for each pool of loans to reflect any current conditions that are expected to result in loss recognition. Factors that we consider include, but are not limited to:
 
·  
effects of any changes in lending policies and procedures, including those for underwriting, collection, charge-offs, and recoveries;
 
·  
changes in the experience, ability and depth of our lending management and staff;
 
·  
concentrations of credit that might affect loss experience across one or more components of the portfolio;
 
·  
levels of, and trends in, delinquencies and nonaccruals; and
 
·  
national and local economic business trends and conditions.
 
Historical loss rates are reviewed and adjusted for the above factors on a pool-by-pool basis. Rates for each pool are based on those factors management believes are applicable to that pool. When applied to a pool of loans or leases, the adjusted historical loss rate is a measure of the total inherent losses in the portfolio that would have been estimated if each individual loan or lease had been reviewed. For such pools of loans or leases, management believes that coverage of one year’s losses in the current portfolio is an appropriate measure.
 
34
 
Net charge-offs as a percentage of our year end portfolio balance, or “net loss experience,” has averaged 0.47% for our commercial loan portfolio over the past five calendar years. However, because a significant portion of our business is focused on commercial lending, we have generally maintained a conservative reserve for our commercial loan portfolio. For the portion of our commercial loan portfolio adequately secured with real estate collateral, we maintain a general reserve equal to 0.35% of the outstanding balance of such portfolio. The reserve for commercial loans that are not secured by real estate is equal to 2.52% of the outstanding portfolio balance.
 
Our consumer installment closed end loan portfolio has averaged a 3.32% net loss experience over the past five calendar years. This is partially attributable to the fact that, in connection with our acquisitions of other banks, additional reserves have been built into the transaction pricing to compensate for future losses. For our consumer loan portfolio, we maintain a general reserve equal to 2.33% of the outstanding balance of such portfolio.
 
Our four year old construction loan portfolio has no loss experience. Nevertheless, we maintain a general reserve for this portfolio equal to 1.50% of the portfolio balance.
 
Our leasing portfolio has averaged a 0.40% net loss experience over the past four calendar years. We maintain a reserve equal to 0.86% of the balance of this portfolio for general reserve purposes.
 
The mortgage portfolio has no loss experience. The large majority of mortgage originations are sold into the secondary market or to other financial institutions and the existing portfolio is generally of a mature nature. Nevertheless, we maintain a general reserve equal to 0.67% of the mortgage portfolio.
 
At March 31, 2005, we maintain a $2.3 million general allowance on the boat financing portfolio, or 5.17% of the outstanding portfolio. While we may adjust this allowance in the future, we believe it is appropriate at this time.
 
All internal and external factors that may impact the adequacy of our general reserves are reviewed on an ongoing basis with formal recommendations being made to the Board of Directors at least annually, and more frequently if deemed necessary.
 
In addition to our general portfolio allowances, specific allowances are established in cases where management has identified significant conditions or circumstances related to a credit that management believes indicate a high probability that a loss will be incurred. This amount may be determined either by a method prescribed by SFAS No. 114, Accounting by Creditors for Impairment of a Loan, or by a method that identifies certain qualitative factors.
 
Through periodic management review at branch and executive level and utilization of internal delinquency processes, both portfolios and individual loans and leases are monitored on an ongoing basis. When considered appropriate, a specific allowance will be considered on individual loan or lease accounts. A review is generally conducted of all the conditions surrounding any particular account such as the borrower’s character, existing and potential financial condition, realizable value of collateral, prospects for additional collateral and payment record. As a result, the loss potential is determined and specific allowances may be established. The level of allowance will vary depending on the analysis but we utilize the same classification categories as federal regulators, which result in varying amounts of reserve depending on loss potential.
 
The unallocated portion of the allowance contains amounts that are based on management’s evaluation of conditions that are not directly measured in the determination of the formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The conditions evaluated in connection with the unallocated portion of the allowance include the following:
 
·  
general economic and business conditions affecting our key lending areas;
 
·  
then-existing economic and business conditions of areas outside the lending areas, such as other sections of the United States and Caribbean;
 
·  
credit quality trends, including trends in nonperforming loans and leases expected to result from existing conditions;
 
·  
loan and lease concentrations by collateral and by obligor;
 
·  
specific industry conditions within portfolio segments;
 
35
 
·  
recent loss experience in particular segments of the portfolio;
 
·  
duration of the current business cycle;
 
·  
bank regulatory examination results and guidance; and
 
·  
findings of our internal and external loan review examiners.
 
Our loan review officer reviews these conditions on an ongoing basis in discussion with our executive management, senior lenders and credit officers. To the extent that any of these conditions is evidenced by a specifically identifiable problem credit or portfolio segment as of the evaluation date, management’s estimate of the effect of such condition may be reflected as a specific allowance, applicable to such loan or portfolio segment. When any of these conditions is not evidenced by a specifically identifiable problem loan or portfolio segment, management’s evaluation of the probable loss related to such conditions is reflected in the unallocated portion of the allowance.
 
Although our management believes that the allowance for loan and lease losses is adequate to absorb probable losses on existing loans and leases that may become uncollectible, there can be no assurance that our allowance will prove sufficient to cover actual loan and lease losses in the future. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the adequacy of our allowance for loan and lease losses. Such agencies may require us to make additional provisions to the allowance based upon their judgments about information available to them at the time of their examinations.
 
The table below summarizes, for the periods indicated, loan and lease balances at the end of each period, the daily averages during the period, changes in the allowance for loan and lease losses arising from loans and leases charged-off, recoveries on loans and leases previously charged-off, and additions to the allowance, and certain ratios related to the allowance for loan and lease losses:
 
     
Three months
Ended
March 31, 
    
Year Ended
December 31, 
  
     
2005 
    
2004 
  
     
(Dollars in thousands) 
  
Average total loans and leases outstanding during period
  
$
1,415,205
  
$
1,217,723
  
Total loans and leases outstanding at end of period, including loans held for sale
    
1,438,163
    
1,387,613
  
Allowance for loan and lease losses:
              
Allowance at beginning of period
    
19,039
    
9,394
  
Charge-offs:
              
Real estate — secured
    
—
    
5
  
Commercial and industrial
    
862
    
3,329
  
Consumer
    
385
    
1,196
  
Leases
    
1,743
    
5,806
  
Other loans
    
7
    
164
  
Total charge-offs
    
2,997
    
10,500
  
 
36
 
Recoveries:
              
Real estate — secured
    
—
    
—
  
Commercial and industrial
    
70
    
154
  
Consumer
    
70
    
233
  
Leases
    
526
    
1,741
  
Other loans
    
8
    
15
  
Total recoveries
    
674
    
2,143
  
Net loan and lease charge-offs
    
2,323
    
8,357
  
Provision for loan and lease losses
    
1,250
    
7,100
  
Allowance of acquired bank - BankTrust
    
—
    
10,902
  
Allowance at end of period
  
$
17,966
  
$
19,039
  
Ratios:
              
Net loan and lease charge-offs to average total loans(1)
    
0.66
%
  
0.69
%
Allowance for loan and lease losses to total loans at end of period
    
1.25
    
1.37
  
Net loan and lease charge-offs to allowance for loan losses at end of period*
    
51.72
    
43.89
  
Net loan and lease charge-offs to provision for loan and lease losses
    
185.84
    
117.70
  
 
__________
(1) Annualized as of March 31, 2005.
 
The allowance for loan and lease losses decreased by 5.6%, or $1.1 million, to $18.0 million at March 31, 2005, as compared to $19.0 million at December 31, 2004. The allowance for loan and lease losses as a percentage of total loans and leases decreased to 1.25% at March 31, 2005 from 1.37% at December 31, 2004. The decrease in the allowance for loan and lease losses was impacted by approximately $703,000 in net charge-offs on loans acquired from The Bank & Trust of Puerto Rico, in which adequate allowances were also required and accordingly, additional provision was not considered necessary to replenish the reduction in the allowance.
 
In June 2004, we commenced the practice of charging-off most of our lease finance contracts that were over 365 days past due. This full charge-off is made on a quarterly basis. Accordingly, most of our lease finance contracts that are over 365 days past due at the end of the quarter are fully charged-off. As of March 31, 2005, $327,000 was charged resulting from this practice.
 
In March 2003, we commenced the practice of effecting partial charge-off on all lease finance contracts that were over 120 days past due. This is done based on our historical lease loss experience. For the three months ended on March 31, 2005 and year 2004, we used a historical loss ratio in lease finance contracts of approximately 15% and 12.0%, respectively. This partial charge-off is made on a quarterly basis. Accordingly, all lease finance contracts that are over 120 days past due at the end of the quarter are partially charged-off. As of March 31, 2005, $916,000 had been charged off for this purpose.
 
Annualized net charge-offs as a percentage of average loans was 0.66% for the first quarter of 2005, as compared to 0.69% and 0.44% for the fourth and first quarter of 2004, respectively. Increased shown when comparing the first quarter of 2005 with 2004 same period is attributable to increased volumes in the loan and lease portfolio, to our decision to fully charge off our lease finance contracts that are over 365 days past due, and also to the net charge-offs related with the acquisition of BankTrust, as explained previously.
 
Net charge-offs as a percentage of provision for loan and lease losses increased to 185.84% as of March 31, 2005, from 117.70% at December 31, 2004. The increase in this ratio was mainly attributable to our decision to fully charge off most of our lease finance contracts that are over 365 days past due.
 
Nonearning Assets
 
Premises, leasehold improvements and equipment, net of accumulated depreciation and amortization, totaled $11.5 million at March 31, 2005 and $11.3 million at December 31, 2004. We have no definitive agreements regarding acquisition or disposition of owned or leased facilities and, for the near-term future, we do not expect significant changes in our total occupancy expense.
 
37
 
Deposits
 
Deposits are our primary source of funds. The following table sets forth, for the periods indicated, the distribution of our average deposit account balances and average cost of funds on each category of deposits:
 
     
Three Months Ended March 31, 2005 
    
Year Ended December 31, 2004 
  
     
Average Balance
 
 
Percent of Deposits
 
 
Average Rate
 
 
Average Balance
 
Percent of Deposits
 
Average Rate
  
     
(Dollars in thousands)  
  
                                   
Noninterest-bearing demand deposits
  
$
126,025
    
8.87
%
  
-
%
$
119,847
  
9.39%
  
-
%
Money market deposits
    
76,946
    
5.42
    
2.13
    
62,346
  
4.88
  
2.14
  
NOW deposits
    
49,400
    
3.48
    
1.81
    
40,931
  
3.21
  
1.80
  
Savings deposits
    
277,048
    
19.50
    
2.24
    
261,660
  
20.50
  
2.38
  
Time certificates of deposit in denominations of $100,000 or more
    
196,114
    
13.80
    
3.04
    
203,129
  
15.91
  
2.16
  
Brokered certificates of deposits in denominations of $100,000 or more
    
515,839
    
36.31
    
3.71
    
396,531
  
31.07
  
3.79
  
Other time deposits
    
179,257
    
12.62
    
2.94
    
192,046
  
15.04
  
2.92
  
Total deposits
  
$
1,420,629
    
100.00
%
      
$
1,276,490
  
 
100.00%
      
                         
Total deposits at March 31, 2005 and December 31, 2004 were $1.446 billion and $1.409 million, respectively, representing an increase of $37.1 million, or 2.63%, in the first three months of 2005. Average deposits for the first quarter of 2005 were $1.4 billion, as compared to $1.0 million for the same period in 2004. This increase in average deposits during the first quarter of 2005 is attributable to our organic growth. The following table presents the composition of our deposits by category as of the dates indicated:
 
     
As of March 31,  
    
As of December 31, 
  
     
2005 
    
2004 
  
     
(In thousands)    
  
Interest bearing deposits:
              
Now and money market
  
$
127,189
  
$
118,076
  
Savings
    
276,484
    
278,802
  
Broker certificates of deposits in denominations of less than $100,000
    
11,998
    
24,115
  
Broker certificates of deposits in denominations of $100,000 or more
    
541,298
    
487,890
  
Time certificates of deposits in denominations of $100,000 or more
    
197,868
    
200,474
  
Other time deposits
    
155,997
    
161,783
  
Total interest bearing deposits
  
$
1,310,834
  
$
1,271,140
  
Plus: non interest bearing deposits
    
135,294
    
137,896
  
Total deposits
  
$
1,446,128
  
$
1,409,036
  
 
In addition to the deposits we generate locally, we have also accepted brokered deposits to augment retail deposits and to fund asset growth. In order to take advantage of historically low funding costs, brokered deposits increased to $553.3 million as of March 31, 2005 from $512.0 million as of December 31, 2004. Most of our brokered deposits have maturities of one to seven years. Because brokered deposits are generally more volatile and interest rate sensitive than other sources of funds, management closely monitors growth in this category.
 
38
 
The following table sets forth the amount and maturities of the time deposits of $100,000 or more as of the dates indicates:
 
   
March 31, 2005 
    
December 31, 2004
  
 
  
(In thousands) 
Three months or less
  
$
186,994
  
$
140,228
  
Over three months through six months
    
83,867
    
74,461
  
Over six months through 12 months
    
96,999
    
108,064
  
Over 12 months
    
371,306
    
365,591
  
Total
  
$
739,166
  
$
688,364
  
 
Other Sources of Funds
 
Securities Sold Under Agreements to Repurchase
 
To support our asset base, we sell securities subject to obligations to repurchase to securities dealers and the FHLB. These repurchase transactions generally have maturities of one month to less than five years. The following table summarizes certain information with respect to securities under agreements to repurchase for the three months ended March 31, 2005 and December 31, 2004:
 
 
   
Three Months Ended
March 31, 
 
 
Year  Ended
December 31,
  
 
    
2005
    
2004
  
     
(Dollars in thousands) 
  
Balance at period-end
  
$
442,160
  
$
463,409
  
Average monthly aggregate balance outstanding during the period
    
447,365
    
312,169
  
Maximum aggregate balance outstanding at any month-end
    
463,244
    
465,302
  
Weighted average interest rate for the period
    
2.59
%
  
1.70
%
Weighted average interest rate at period-end
    
2.83
%
  
2.47
%
 
FHLB Advances
 
Although deposits and repurchase agreements are the primary source of funds for our lending and investment activities and for general business purposes, we may obtain advances from the Federal Home Loan Bank of New York as an alternative source of liquidity. The following table provides a summary of FHLB advances for the three months ended March 31, 2005 and December 31, 2004:
 
 
 
 
Three Months Ended March 31, 2005 
    
Year Ended
December 31, 2004
  
 
  
 (Dollars in thousands) 
Balance at period-end
  
$
10,396
  
$
10,404
  
Average monthly aggregate balance outstanding during the period
    
10,400
    
10,450
  
Maximum aggregate balance outstanding at any month-end
    
10,404
    
10,700
  
Weighted average interest rate for the period
    
4.78
%
  
5.59
%
Weighted average interest rate at period-end
    
4.86
%
  
4.97
%
 
Notes Payable to Statutory Trusts
 
On December 18, 2001, the Trust issued $25,000,000 of floating rate Trust Preferred Capital Securities Series 1 due in 2031 with a liquidation amount of $1,000 per security. Distributions payable on each capital security is payable at an annual rate equal to 5.60% beginning on (and including) the date of original issuance and ending on (but excluding) March 18, 2002, and at an annual rate for each successive period equal to the three-month LIBOR, plus 3.60% with a ceiling rate of 12.50%. The capital securities of the Trust are fully and unconditionally guaranteed by EuroBancshares. The Company then issued $25,774,000 of floating rate junior subordinated deferrable interest debentures to the Trust due in 2031. The terms of the debentures, which comprise substantially all of the assets of the Trust, are equal to the terms of the capital securities issued by the Trust. These debentures are fully and unconditionally guaranteed by the Bank. The Bank subsequently issued an unsecured promissory note to EuroBancshares for the issued amount and at an annual rate equal to that being paid on the Trust Preferred Capital Securities Series 1 due in 2031.
 
39
 
On December 19, 2002, the Trust II issued $20,000,000 of floating rate Trust Preferred Capital Securities due in 2032 with a liquidation amount of $1,000 per security. Distributions payable on each capital security will be payable at an annual rate equal to 4.66% beginning on (and including) the date of original issuance and ending on (but excluding) March 26, 2003, and at an annual rate for each successive period equal to the three-month LIBOR plus 3.25% with a ceiling rate of 11.75%. The capital securities of the Trust II are fully and unconditionally guaranteed by EuroBancshares. The Company then issued $20,619,000 of floating rate junior subordinated deferrable interest debentures to the Trust II due in 2032. The terms of the debentures, which comprise substantially all of the assets of the Trust II, are equal to the terms of the capital securities issued by the Trust II. These debentures are fully and unconditionally guaranteed by the Bank. The Bank subsequently issued an unsecured promissory note to the EuroBancshares for the issued amount and at an annual rate equal to that being paid on the Trust Preferred Capital Securities due in 2032.
 
Prior to FIN No. 46R, the statutory trusts described above, were considered subsidiaries of the Company. As a result of the adoption of FIN No. 46R, the Company deconsolidated these statutory trusts effective December 31, 2003. The junior subordinated debentures issued by the Company to the statutory trusts, totaling $46,393,000 are reflected in the Company’s consolidated balance sheets under the caption of “notes payable to statutory trusts”. The Company records interest expense on the notes payable to statutory trusts in the consolidated statements of income and included in the caption of other investments in the consolidated balance sheets, the common securities issued by the statutory trusts.
 
Interest expense on notes payable to statutory trusts amounted to approximately $699,000 and $535,000 for the periods ended March 31, 2005, and 2004, respectively.
 
The Federal Reserve Board indicated in supervisory letter SR 03-13 (the Supervisory Letter), dated July 2, 2003, that trust preferred securities will be treated as Tier 1 capital until notice is given of the contrary. The Supervisory Letter also indicates that the Federal Reserve will review the regulatory implications of any accounting treatment changes and will provide further guidance if necessary or warranted.
 
On March 1, 2005 the Federal Reserve Board adopted the final rule that allows the continued limited inclusion of trust preferred securities in the tier 1 capital of bank holding companies (BHCs). Under the final rule, trust preferred securities and other restricted core capital elements would be subject to stricter quantitative limits. The Federal Reserve Board’s final rule limits restricted core capital elements to 25% of all core capital elements, net of goodwill less any associated deferred tax liability. Internationally active BHCs, defined as those with consolidated assets greater than $250 billion or on-balance-sheet foreign exposure greater than $10 billion, will be subject to a 15% limit. But they may include qualifying mandatory convertible preferred securities up to the generally applicable 25% limit. Amounts of restricted core capital elements in excess of these limits generally may be included in Tier 2 capital. The final rule provides a five-year transition period, ending March 31, 2009, for application of the quantitative limits.
 
Capital Resources and Capital Adequacy Requirements
 
We are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can trigger regulatory actions that could have a material adverse effect on our business, financial condition, results of operations, cash flows and/or future prospects. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that rely on quantitative measures of our assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.
 
We monitor compliance with bank regulatory capital requirements, focusing primarily on the risk-based capital guidelines. Under the risk-based capital method of capital measurement, the ratio computed is dependent on the amount and composition of assets recorded on the balance sheet and the amount and composition of off-balance sheet items, in addition to the level of capital. Generally, Tier 1 capital includes common stockholders’ equity our Series A Preferred Stock, our junior subordinated debentures (subject to certain limitations) less goodwill. Total capital represents Tier 1 plus the allowance for loan and lease losses (subject to certain limits).
 
40
 
In the past three years, our primary sources of capital have been internally generated operating income through retained earnings, our initial public offering, a private placement and capital derived from the issuance of the 2002 Debentures. As of March 31, 2005 and December 31, 2004, total stockholders’ equity was $159.6 million and $158.3 million, respectively.
 
We are not aware of any material trends that could materially affect our capital resources other than those described in the section entitled “Risk Factors,” in our Prospectus on Form S-1 dated August 11, 2004.
 
As of March 31, 2005, we and Eurobank both qualified as “well-capitalized” institutions under the regulatory framework for prompt corrective action. The following table presents the regulatory standards for well-capitalized institutions, compared to our capital ratios for Eurobank as of the dates specified:
 
     
Actual
    
For Minimum Capital
Adequacy Purposes
    
To Be Well Capitalized
Under Prompt Corrective
Action Provision
  
 
 
    
Amount Is 
 
 
Ratio Is
 
 
Amount
Must Be
 
 
Ratio
Must Be
 
 
Amount
Must Be
 
 
Ratio
Must Be
 
 
  
(Dollars in thousands) 
As of March 31, 2005:
                                      
Total Capital (to Risk Weighted Assets)
                                      
EuroBancshares, Inc
  
$
228,168
    
13.84
%
 
≥$131,850
    
≥ 8.00
%
  
N/A
        
Eurobank.
    
177,350
    
10.71
    
≥ 132,526
    
≥ 8.00
    
≥$165,658
    
≥ 10.00
%
Tier 1 Capital (to Risk Weighted Assets)
                                      
EuroBancshares, Inc
    
209,998
    
12.74
    
≥ 65,925
    
≥ 4.00
    
N/A
        
Eurobank
    
139,180
    
8.40
    
≥ 66,263
    
≥ 4.00
    
≥ 99,395
    
≥ 6.00
  
Leverage (to average assets)
                                      
EuroBancshares, Inc
    
209,998
    
9.99
    
≥ 84,045
    
≥ 4.00
    
N/A
        
Eurobank
    
139,180
    
6.63
    
≥ 83,983
    
≥ 4.00
    
≥ 104,979
    
≥ 5.00
  
As of December 31, 2004:
                                      
Total Capital (to Risk Weighted Assets)
                                      
EuroBancshares, Inc
  
$
220,585
    
13.94
%
 
≥$126,564
    
≥ 8.00
%
  
N/A
        
Eurobank.
    
169,705
    
10.67
    
≥ 127,286
   
≥ 8.00
    
≥$159,108
    
≥ 10.00
%
Tier 1 Capital (to Risk Weighted Assets)
                                      
EuroBancshares, Inc
    
201,342
    
12.73
    
≥ 63,282
   
≥ 4.00
    
N/A
        
Eurobank
    
130,461
    
8.20
    
≥ 63,643
   
≥ 4.00
    
≥ 95,465
    
≥ 6.00
  
Leverage (to average assets)
                                      
EuroBancshares, Inc
    
201,342
    
9.91
    
≥ 81,303
   
≥ 4.00
    
N/A
        
Eurobank
    
130,461
    
6.42
    
≥ 81,244
   
≥ 4.00
    
≥ 101,555
    
≥ 5.00
  

 
Liquidity Management
 
Maintenance of adequate liquidity requires that sufficient resources be available at all times to meet our cash flow requirements. Liquidity in a banking institution is required primarily to provide for deposit withdrawals and the credit needs of customers and to take advantage of investment opportunities as they arise. Liquidity management involves our ability to convert assets into cash or cash equivalents without incurring significant loss, and to raise cash or maintain funds without incurring excessive additional cost. For this purpose, we maintain a portion of our funds in cash and cash equivalents, deposits in other financial institutions and loans and securities available for sale. Our liquid assets at March 31, 2005 and December 31, 2004 totaled approximately $156.9 million and $171.2 million, respectively. Our liquidity level measured as a percentage of net cash, short-term and marketable assets to net deposits and short-term liabilities was 12.4% and 14.2% as of March 31, 2005 and December 31, 2004, respectively.
 
41
 
As a secondary source of liquidity, we rely on advances from the FHLB to supplement our supply of lendable funds and to meet deposit withdrawal requirements. Advances from the FHLB are typically secured by qualified residential and commercial mortgage loans, and investment securities. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution’s net worth or on the FHLB’s assessment of the institution’s creditworthiness. Other funding alternatives available are local and United States conventional and brokered time deposits, unsecured lines of credit with correspondent banks, borrowing lines with brokers and the Federal Reserve Bank of New York. To participate in the broker time deposits market, we must be categorized as “well capitalized” under the regulatory framework for prompt corrective action unless we obtain a waiver from the FDIC. Restrictions on our ability to participate in this market could place limitations on our growth strategy or could result in our participation in other more expensive funding sources. Our expansion strategies will have to be reviewed to reflect the possible limitation to funding sources and changes in cost structures. We do not foresee any changes in our capital ratios that would restrict our ability to participate in the brokered deposit market. Our target liquidity ratio established in our Liquidity Policy of liquid assets as a percentage of net deposits and short-term liabilities is 10.0%. Our liquidity demands are not seasonal and all trends have been stable over the last three years. We are not aware of any trends or demands, commitments, events or uncertainties that will result in or that are reasonably likely to materially impair our liquidity. Generally, financial institutions determine their target liquidity ratios internally, based on the composition of their liquidity assets and their ability to participate in different funding markets that can provide the required liquidity. In addition, the local market has characteristics make it impossible to compare our liquidity needs and sources to the liquidity needs and sources of our peers in the rest of the nation. After careful analysis of the diversity of liquidity sources available to us, our asset quality and the historic stability of our core deposits, we have determined that our target liquidity ratio is adequate.
 
In addition to the normal influx of liquidity from core deposit growth, together with repayments and maturities of loans and investments, we utilize brokered and out-of-market certificates of deposit, FHLB borrowings and broker-dealer repurchase agreements to meet our liquidity needs. The FHLB borrowings are collateralized by first mortgage residential loans, selected investment securities and FHLB stock. Pre-approved repurchase agreement availability with major brokers and banks totaled $350.0 million at March 31, 2005, subject to acceptable unpledged marketable securities available for sale. In addition, Eurobank is able to borrow from the Federal Reserve Bank using securities as collateral. Eurobank also maintains pre-approved overnight borrowing lines at various correspondent banks, which provided additional short-term borrowing capacity of $17.5 million at March 31, 2005.
 
During first three months of 2005, asset growth was funded primarily with growth in deposits. The deposit growth was distributed as follows as of March 31, 2005: $6.5 million increase in demand deposits; $2.0 million decrease in savings accounts; $32.6 million increase in time deposits of which $41.5 million was comprised of brokered deposits. There was a decrease of $21.2 million in the level of borrowings, which was primarily attributable to securities sold under agreements to repurchase. During the first quarter of 2005, cash inflows from operating activities exceeded cash outflows by $7.6 million.
 
During year 2004, deposit growth was distributed as follows: $75.0 million in demand deposits; $48.7 million in savings accounts; $301.6 million in time deposits of which $282.9 million was comprised of brokered deposits. The increase in the level of borrowings was primarily attributable to securities sold under agreements to repurchase of $255.9 million. During 2004, cash inflows from operating activities exceeded cash outflows by $38.3 million.
 
Our net cash outflows from investing activities for the three months ended March 31, 2005 and for the year 2004 were $22.0 million and $294.7 million, respectively. The higher net investing cash outflows experienced in 2004 were primarily due to growth in the investment securities portfolio, which provided additional collateral in that year to support wholesale funding increases.
 
Our net cash inflows from financing activities for the three months ended March 31, 2005 and the year 2004 were $15.6 million and $252.5 million, respectively. During the first three months of 2005 the net financing cash inflows were primarily provided by repurchase agreements growth. During 2004, the net financing cash inflows were mostly provided by repurchase agreements growth and the net proceeds from the issuance of common stock.
 
Quantitative and Qualitative Disclosure About Market Risks
 
Interest rate risk is the most significant market risk affecting us. Other types of market risk, such as foreign currency risk and commodity price risk, do not arise in the normal course of our business activities. Interest rate risk can be defined as the exposure to a movement in interest rates that could have an adverse effect on our net interest income or the market value of our financial instruments. The ongoing monitoring and management of this risk is an important component of our asset and liability management process, which is governed by policies established by Eurobank’s Board of Directors and carried out by Eurobank’s Asset/Liability Management Committee. The Asset/Liability Management Committee’s objectives are to manage our exposure to interest rate risk over both the one year planning cycle and the longer term strategic horizon and, at the same time, to provide a stable and steadily increasing flow of net interest income. Interest rate risk management activities include establishing guidelines for tenor and repricing characteristics of new business flow, the maturity ladder of wholesale funding, investment security purchase and sale strategies and mortgage loan sales, as well as derivative financial instruments. Eurobank may enter into interest rate swap agreements, in which it exchanges the periodic payments, based on a notional amount and agreed-upon fixed and variable interest rates. At March 31, 2005, the Bank had interest rate swap agreements which converted $50.2 million of fixed rate time deposits to variable rate time deposits of which $19.4 million will mature in 2005 and 2006 and $30.8 million with maturity between 2010 and 2023 but with semi-annual call options which match call options on the swaps. At March 31, 2005, the Bank had interest rate swap agreements which converted $42.5 million of variable rate loans to fixed rate loans, of which $12.0 million mature in 2006 and $30.5 million mature in 2007. For more detail on derivative financial instruments please refer to “Note 12 - Derivative Financial Instruments” of the condensed consolidated financial statements included herein.
 
42
 
Our primary measurement of interest rate risk is earnings at risk, which is determined through computerized simulation modeling. The primary simulation model assumes a static balance sheet, using the balances, rates, maturities and repricing characteristics of all of the Bank’s existing assets and liabilities, including off-balance sheet financial instruments. Net interest income is computed by the model assuming market rates remaining unchanged and compares those results to other interest rate scenarios with changes in the magnitude, timing and relationship between various interest rates. At March 31, 2005, we modeled rising and declining interest rate simulations in 100 basis point increments over a twelve month period. The impact of imbedded options in such products as callable and mortgage-backed securities, real estate mortgage loans and callable borrowings were considered. Changes in net interest income in the rising and declining rate scenarios are then measured against the net interest income in the rates unchanged scenario. The Asset/Liability Management Committee utilizes the results of the model to quantify the estimated exposure of net interest income to sustained interest rate changes.
 
In the March 31, 2005 simulation, our model indicated an exposure in the level of net interest income to rising rates for a 12-month period. The hypothetical rate scenarios consider a change of 100 and 200 basis points during a 12-month period. The decreasing rate scenarios have a floor of 200 basis points. This floor causes liabilities to have little cost reduction, while assets do have a decrease in yields, causing a small loss in declining rate simulations of 200 basis points. At March 31, 2005, the net interest income at risk for year one in the 100 basis point falling rate scenario was calculated at $660,000, or 0.97% lower than the net interest income in the rates unchanged scenario, and $1.5 million, or 2.25%, lower than the net interest income in the rates unchanged scenario at the March 31, 2005 simulation with a 200 basis point decrease. These exposures are well within our policy guidelines of 15.0%. At March 31, 2005, the net interest income for year one in the 100 basis point rising rate scenario was calculated to be $1.4 million, or 2.13%, higher than the net interest income in the rates unchanged scenario, and $2.8 million, or 4.17%, higher than the net interest income in the rate unchanged scenario at the March 31, 2005 simulation with a 200 basis point increase. Computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan and security prepayments, deposit run-offs and pricing and reinvestment strategies and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions we may take in response to changes in interest rates. We cannot assure you that our actual net interest income would increase or decrease by the amounts computed by the simulations. The following table indicates the estimated impact on net interest income under various interest rate scenarios as of March 31, 2005:
 
 
Change in Future
Net Interest Income  
 
  
At March 31, 2005  
Change in Interest Rates
    
Dollar Change
    
Percentage Change
  
 
  
(Dollars in thousands) 
+200 basis points over one year
  
$
2,832
    
4.17
%
+100 basis points over one year
    
1,443
    
2.13
  
- 100 basis points over one year
    
(660
)
  
(0.97
)
- 200 basis points over one year
    
(1,526
)
  
(2.25
)
               
 
We also monitor the repricing terms of our assets and liabilities through gap matrix reports for the rates in unchanged, rising and falling interest rate scenarios. The reports illustrate, at designated time frames, the dollar amount of assets and liabilities maturing or repricing.
 
The following table sets forth, on a stand-alone basis, Eurobank’s amounts of interest-earning assets, interest-bearing liabilities and the nominal amount of interest rate swaps outstanding at March 31, 2005, which we anticipate, based upon certain assumptions, to reprice or mature in each of the future time periods shown. The projected repricing of assets and liabilities anticipates prepayments and scheduled rate adjustments, as well as contractual maturities under an interest rate unchanged scenario within the selected time intervals. While we believe such assumptions are reasonable, we cannot assure you that assumed repricing rates will approximate our actual future deposit activity.
 
 
43
 
 
 
  
As of March 31, 2005
Volumes Subject to Repricing Within  
   
0-1
Days  
 
 
2-180
Days
 
 
181-365
Days
 
 
1-3
Years
 
 
Over
3 Years
 
 
Non-Interest
Sensitive
 
 
Total
 
 
  
(Dollars in thousands) 
Assets:
                                            
Short-term investments and federal funds sold
  
$
25,505
  
$
—
  
$
—
  
$
—
  
$
—
  
$
—
  
$
25,505
  
Investment securities and FHLB/ Federal Reserve Bank stock
    
—
    
96,332
    
128,450
    
234,910
    
136,276
    
—
    
595,968
  
Loans
    
—
    
774,493
    
76,897
    
275,557
    
293,250
    
—
    
1,420,197
  
Fixed and other assets
    
—
    
1,385
    
—
    
—
    
—
    
77,394
    
78,779
  
Total swaps
    
—
    
—
    
9,442
    
20,785
    
20,000
    
—
    
50,227
  
Total assets
  
$
25,505
  
$
872,210
  
$
214,789
  
$
531,252
  
$
449,526
  
$
77,394
  
$
2,170,676
  
                                             
                                             
Liabilities and Stockholders’ Equity:
                                            
Interest-bearing checking, savings and money market accounts
    
—
    
76,055
    
546
    
—
    
—
    
462,911
    
539,512
  
Certificates of deposit
    
—
    
331,515
    
127,958
    
260,164
    
188,448
    
—
    
908,085
  
Borrowed funds
    
—
    
430,360
    
17,830
    
23,426
    
25,940
    
—
    
497,556
  
Other liabilities
    
—
    
1,393
    
—
    
—
    
—
    
14,328
    
15,721
  
Total swaps payable
    
—
    
50,227
    
—
    
—
    
—
    
—
    
50,227
  
Stockholders’ equity
    
—
    
10,763
    
—
    
—
    
—
    
148,812
    
159,575
  
Total liabilities and stockholders’ equity
  
$
—
  
$
900,313
  
$
146,334
  
$
283,590
  
$
214,388
  
$
626,051
  
$
2,170,676
  
Period gap
  
$
25,505
  
$
(28,103
)
$
68,455
  
$
247,662
  
$
235,138
              
Cumulative gap
  
$
25,505
  
$
(2,598
)
$
65,857
  
$
313,519
  
$
548,657
              
Period gap to total assets
    
1.18
%
  
-1.30
%
  
3.16
%
  
11.42
%
  
10.85
%
            
Cumulative gap to total assets
    
1.18
%
  
-0.12
%
  
3.04
%
  
14.46
%
  
25.31
%
            
Cumulative interest-earning assets to cumulative interest-bearing liabilities
    
N/A
    
99.71
%
  
106.30
%
  
123.59
%
  
135.55
%
            
                                             
Certain shortcomings are inherent in the method of analysis presented in the gap table. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Additionally, certain assets, such as adjustable-rate loans, have features that restrict changes in interest rates, both on a short-term basis and over the life of the asset. More importantly, changes in interest rates, prepayments and early withdrawal levels may deviate significantly from those assumed in the calculations in the table. As a result of these shortcomings, we focus more on earnings at risk simulation modeling than on gap analysis. Even though the gap analysis reflects a ratio of cumulative gap to total assets within acceptable limits, the earnings at risk simulation modeling is considered by management to be more informative in forecasting future income at risk.
 
Finally, we also monitor core funding utilization in each interest rate scenario as well as market value of equity. These measures are used to evaluate long-term interest rate risk beyond the two-year planning horizon.
 
Aggregate Contractual Obligations
 
The following table represents our on and off-balance sheet aggregate contractual obligations, other than deposit liabilities, to make future payments to third parties as of the date specified:
 
 
  
As of March 31, 2005  
   
Less than
One Year 
 
 
One Year to
Three Years
 
 
Over Three Years
to Five Years
 
 
Over Five Years
  
 
  
(In thousands) 
FHLB advances
  
$
8,600
  
$
1,200
  
$
—
  
$
596
  
Notes payable to statutory trusts
    
—
    
—
    
—
    
46,393
  
Operating leases
    
2,197
    
3,642
    
2,095
    
9,362
  
Total
  
$
10,797
  
$
4,842
  
$
2,095
  
$
56,351
  
 
 
44
 
Off-Balance Sheet Arrangements
 
During the ordinary course of business, we provide various forms of credit lines to meet the financing needs of our customers. These commitments, which have a term of less than one year, represent a credit risk and are not represented in any form on our balance sheets.
 
As of March 31, 2005 and December 31, 2004, we had commitments to extend credit of $268.3 million and $269.4 million, respectively. These commitments included standby letters of credit of $10.6 and $10.5 million, for March 31, 2005 and December 31, 2004, respectively, and commercial letters of credit of $1.4 million and $1.8 for the same periods. Starting in the fiscal year 2003, in accordance with FIN 45, it is our policy to recognize the estimated fair value of our obligations under standby letters of credit issued, which are then reduced by credits to earnings as we are released from the stand-ready risk. However, at December 31, 2004 and March 31, 2005, no obligation was recorded since the amounts were inconsequential.
 
The effect on our revenues, expenses, cash flows and liquidity of the unused portions of these commitments cannot reasonably be predicted because there is no guarantee that the lines of credit will be used.
 
Recent Accounting Pronouncements
 
In December 2004, the SFAS No. 123 was revised. This statement establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services. It also addresses transactions in which an entity incurs liabilities in exchange for goods or services that are based on the fair value of the entity’s equity instruments or that may be settled by the issuance of those equity instruments. This statement focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award—the requisite service period (usually the vesting period). No compensation cost is recognized for equity instruments for which employees do not render the requisite service. Employee share purchase plans will not result in recognition of compensation cost if certain conditions are met; those conditions are much the same as the related conditions in SFAS No. 123. A public entity will initially measure the cost of employee services received in exchange for an award of liability instruments based on its current fair value; the fair value of that award will be remeasured subsequently at each reporting date through the settlement date. Changes in fair value during the requisite service period will be recognized as compensation cost over that period. Under the SEC’s rule, approved in April 2005, FAS 123 (R) will be effective, for public entities that do not file as small business issuers, for annual, rather than interim periods that begin after June 15, 2005. The Company expects to adopt this new implementation for the first quarter of 2006.
 
Recent Developments
 
Changes in statutes and regulations, including tax laws and rules
 
During the first quarter of 2005, the Puerto Rico Treasury Department drafted a proposal to impose a transitory additional tax applicable to Puerto Rico financial institutions, which if approved, will be effective for the taxable years commencing on January 1, 2005 until December 31, 2006. The additional tax will be 4% of the net interest income, as defined, excluding exempt interest earned, net of the related interest expense, on obligations of the United States, of any state or territory of the United States or political subdivision, of the District of Columbia, and of the Commonwealth of Puerto Rico or any instrumentality or political subdivision. A draft of the proposal was submitted to the Puerto Rico Legislature and the Governor of Puerto Rico for review and approval. However, no determination can be made at this point as to the outcome of this review.
 
This proposal, based on the financial results for the year ended December 31, 2004 and the distribution of interest income between taxable and exempt, would have implied in an additional tax in the range of approximately $2.4 million to $2.5 million for the year ended December 31, 2004. However, the final impact of this proposal will depend on the final bill, if approved, and in regulations issued thereafter.
 

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ITEM 3.   Quantitative and Qualitative Disclosures about Market Risk
 
The information contained in the section captioned “Management’s Discussion and Analysis of Financial Condition and Results of Operations” as set forth in Part I, Item 2 of this Quarterly Report on Form 10-Q is incorporated herein by reference.
 
ITEM 4.   Controls and Procedures
 
Introductory Note. As of December 31, 2004, the date of our last Annual Report on Form 10-K, we were not an accelerated filer within the meaning of Rule 12b-2 of the Securities Exchange Act of 1934, as amended. As such, we were not subject to the internal control over financial reporting requirements of Section 404 of the Sarbanes-Oxley Act that require us to include in our Annual Report on Form 10-K a report by management of our internal control over financial reporting and an accompanying auditor’s report. However, our subsidiary bank, Eurobank, was subject to the reporting obligations under Section 36 of the Federal Deposit Insurance Act which contains certain reporting requirements of the Bank that are similar to those contained in Section 404, including the delivery of a report of management of the Bank as to the effectiveness of the Bank’s internal control structure and procedures for financial reporting. The information set forth below with respect to the identification of an internal control deficiency in Eurobank’s internal control over financial reporting as of December 31, 2004 were disclosed only for purposes of Eurobank’s compliance with its reporting obligations under Section 36 of the Federal Deposit Insurance Act and should not be read in the context of any similar reporting requirement under Section 404 of the Sarbanes-Oxley Act.
 
Disclosure Controls and Procedures. As of the end of the period covered by this Quarterly Report on Form 10-Q for the quarter ended March 31, 2005, we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our “disclosure controls and procedures,” as such term is defined under Exchange Act Rule 13a-15(e) and 15d-15(e).
 
Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of the end of the fiscal quarter covered by this report, such disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is: (a) recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission, and (b) accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure. The conclusion as to the ineffectiveness of our disclosure controls and procedures as of March 31, 2005, was based on the identification of a material weakness as described below and in our Annual Report on Form 10-K for the year ended December 31, 2004.
 
In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and in reaching a reasonable level of assurance our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
 
Except as noted below, there were no other changes in our internal controls over financial reporting during the quarter ended March 31, 2005 that materially affected, or were reasonably likely to materially affect, our internal controls over financial reporting.
 
Remediation of Material Weakness of Eurobank. In connection with the preparation of our Annual Report on Form 10-K as of December 31, 2004, an evaluation was performed with the participation of the CEO and CFO, of the effectiveness of our disclosure controls and procedures as required by Rule 13a-14 of the Exchange Act. In addition, management of Eurobank assessed the effectiveness of the Bank’s internal control over financial reporting as of December 31, 2004. In making its assessment of internal control over financial reporting, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control—Integrated Framework. In performing this assessment, management identified a deficiency related to accounting for certain derivative financial instruments that were acquired in connection with our acquisition of BankTrust in May 2004 under Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (“SFAS 133”). Specifically, the deficiency resulted from the lack of adequate controls designed to ensure that the documentation, monitoring and evaluation required by generally accepted accounting principles was properly maintained for the term of the respective derivative financial instrument and that such documentation provided reasonable assurance to support the ongoing monitoring of the Bank’s hedging activities. Management concluded that the amounts involved with respect to these derivative financial instruments were not material for the periods reported and that prior 2004 interim financial statements need not be revised.
 
46
 
Management evaluated the impact of this deficiency on Eurobank assessment of internal control over financial reporting and concluded that the control deficiency described above represented a material weakness (as defined in Auditing Standard No. 2 by the Public Company Accounting Oversight Board). Accordingly, management concluded that, as of December 31, 2004, Eurobank’s internal control over financial reporting may not be effective based on the criteria set forth by the COSO in Internal Control—Integrated Framework.
 
As a result of this matter, we discontinued the use of hedge accounting under SFAS 133 during the first quarter of 2005. In addition, in April 2005, we terminated certain cash-flow hedges and re-designated all remaining derivatives as fair-value hedges. Corrective actions to formalize our control procedures with regard to this deficiency are in process. While we believe that our existing disclosure controls and procedures have been effective to accomplish these objectives, we intend to continue to examine, refine and formalize our disclosure controls and procedures and to monitor ongoing developments in this area.
 
PART II -  
OTHER INFORMATION
 
ITEM 1.        Legal Proceedings
 
We are currently the defendant in a suit filed on November 14, 1994 by Carlos Gonzalez Jusino in the Superior Court of Puerto Rico, Ponce Section (Carlos Gonzalez Jusino v. Eurobank & Trust Company — Civil #JAC 1994-0608). The complaint alleges that money was permitted to be withdrawn from a corporate account at Eurobank without full written authorization, and seeks restoration of $890,075.99 in funds, interest thereon, and attorney’s fees. While the trial court found in favor of the plaintiff, we appealed the ruling to the Appeals Court of Puerto Rico. On March 18, 2005, the Appeals Court reversed the trial court’s decision and ruled in our favor. However, on April 27, 2005, the plaintiff filed a writ of certiorari before the Supreme Court of Puerto Rico. If the writ of certiorari is granted, we believe that the Supreme Court will affirm the appeals court decision based on legal precedent which we feel favors our position.
 
Except for the foregoing, there are no material pending legal proceedings to which we or Eurobank is a party or to which any of our properties are subject; nor are there material proceedings known to us, in which any director, officer or affiliate or any principal stockholder is a party or has an interest adverse to us or Eurobank.
 
ITEM 2.         Unregistered Sales of Equity Securities and Use of Proceeds
 
None.
 
ITEM 3.       Defaults Upon Senior Securities
 
None.
 
ITEM 4.       Submission of Matters to a Vote of Security Holders
 
None.
 
ITEM 5.   Other Information
 
Not applicable.
 
ITEM 6.          Exhibits
 
Exhibit Number
  
Description of Exhibit
31.1
  
Rule 13a-14(a) Certification of Chief Executive Officer.
     
31.2
  
Rule 13a-14(a) Certification of Chief Financial Officer.
     
32.1
  
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
32.2
  
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
     
 
 
47
 

SIGNATURES
 
Pursuant to the requirements of the Securities Act of 1934, the registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
     
  EUROBANCSHARES, INC.
 
 		  
 		  
 
Date: May 16, 2005 By:   /s/ Rafael Arrillaga Torréns, Jr.                               
  Rafael Arrillaga Torréns, Jr.
  Chairman of the Board, President and Chief Executive Officer
 
     
Date: May 16, 2005 By:   /s/ Yadira R. Mercado                         
  Yadira R. Mercado
  Chief Financial Officer
 
 
48